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Market Viewpoints

By Manish Singh, Chief Investment Officer, Crossbridge Capital
“Why are people so afraid? The answer is that they have made themselves helpless and dependent on others. We are so lazy, we do not want to do anything ourselves. We want a Personal God, a Saviour or a Prophet to do everything for us.”

Summary

It’s no secret that President Donald Trump loves a weak US dollar and despite the interest rate cut on Wednesday by the US Federal Reserve, the US dollar didn’t weaken, but instead strengthened against the Euro. In my opinion the currency war may have just begun. One of the key promises Trump made to his voters was to bring manufacturing jobs back to America. According to Trump that involves two things – tariffs on imports coming into the US and keeping the US dollar weak to promote US exports. As we know, he is working on the first point already and is very likely to embark on the second one, despite his current denials. A currency war may not necessarily be a bad thing in the overall context of a world suffering from disinflation and low short term rates. It sure is better than a tariff war which leads to a reduction in trade and hence consumption and investments. A currency war can go catastrophically wrong when a country responds to another country’s devaluation of its currency, by imposing tariffs on exports from that country i.e. a currency war that leads to a full-fledged trade war and therefore a reduction in overall trade and economic activity.

Whether or not we will see another interest rate cut in the US later this year, monetary policy will remain on the easy path and the Fed will not raise rates anytime soon. This type of stimulus could eventually result in a bubble, but until the manufacturing and housing sectors stop weakening and inflation starts firming up, there is little to be worried about. If growth in China and the Eurozone trends up, helped by a stimulus in their respective economies, then the future is bright for corporate earnings.

The Currency war

The news this week that President Donald Trump decided not to intervene in the currency markets, to weaken the US dollar, doesn’t at all convince me that he won’t do so in the future. Trump not only held out the possibility that he could take action in the future by saying he hadn’t ruled anything out, “I could do that in two seconds if I wanted to,” adding, “I didn’t say I’m not going to do something.” It’s no secret that Trump loves a weak dollar and despite the interest rate cut on Wednesday by the US Federal Reserve, the US dollar didn’t weaken but instead strengthened against the Euro. In my opinion the currency war may have just begun.

Last week, the European Central Bank (ECB) decided it was ready to cut its already low deposit rate of -0.4% (2.65% below the US Fed Funds Rate) further. The ECB also hinted it was prepared to go further into negative territory. It’s only a matter of time therefore, before the currency war accelerates and becomes the talk of everyday news.

One of the key promises Trump made to his voters was to bring manufacturing jobs back to America. According to Trump that involves two things – tariffs on imports coming into the US and keeping the US dollar weak to promote US exports. As we know, he is already working on the first one and is very likely to embark on the second one despite his denials. He is already leaning on the US Federal Reserve (Fed) heavily in this respect. Earlier this week Trump tweeted – “A small rate cut is not enough” and went on to add – “The EU and China will further lower interest rates and pump money into their systems, making it much easier for their manufacturers to sell product. In the meantime, and with very low inflation, our Fed does nothing – and probably will do very little by comparison. Too bad!”

Over the last ten years the Euro has weakened against the US Dollar by a sizeable -25%, whereas the Chinese Yuan (CNY) has weakened by a mere -0.74%. This week, the Fed delivered a 25bps rate cut. No doubt a “small rate cut” in Trump’s view. The Fed further indicated it was not looking to cut rates further immediately. Meanwhile, the ECB is set to cut rates and embark on a new round of Quantitative Easing (QE) and The People’s Bank of China (PBoC) is getting ready to cut rates too, for the first time in four years.

The latest Fox News Poll shows Trump trailing the top Democratic Presidential contender Joe Biden by 10 points. This, despite Trump reaching the highest approval rating of his Presidency. Trump has promised to boost US GDP growth to +3% or more through his policies of tax cuts, deregulation and a tougher trade stance. The most recent data for the second-quarter of 2019 indicate that the US economy grew at +2.1%. That is down sharply from a +3.1% pace in the first quarter.

Should we be afraid of a currency war?

A currency war may not necessarily be a bad thing in the overall context of a world suffering from disinflation and short term rates. It sure is better than a tariff war which leads to a reduction in trade and hence consumption and investments. One country devaluing its currency spurs another to do the same by printing money i.e. it leads to a spate of monetary expansion and it may lead to higher inflation.

A currency war can go catastrophically wrong when a country responds to another country’s devaluation of its currency by imposing tariffs on exports from that country i.e. a currency war that leads to a full-fledged trade war and protectionism and therefore a reduction in overall trade and economic activity.

In September 1931, Great Britain abandoned the gold standard in a “competitive” devaluation and many other nations followed suit. Nations abandoning the gold standard embarked on the path of aggressive monetary and fiscal expansion and mounted an economic recovery. As the chart above shows, France and the US held on to gold standard longer and this delayed the economic recovery in those countries. This “currency war” cured the world of the Great Depression.

The Great Depression threw up many lessons and there’s one more important lesson to bear in mind. The misguided orthodoxy of monetary policy, then, particularly by France (and the US), made the Depression worse just as the orthodoxy of fiscal policy today by Germany is turning the Eurozone into a sick patient as growth keeps slowing down, unemployment remains high – whilst the ECB keeps lowering deposit rates further into negative territory.

The hoarding of gold by the Bank of France from 1927-32, although a very unfortunate event for the world – as it turned out was not without any basis. It had its origins in the terrible economic conditions that France endured from 1924-26. In 1925 the French Franc fell from 18 per dollar to 27 per dollar. By the following year, the Franc sank further to 49 per dollar, deficits soared and inflation rose to a peak of +346%. Between September 1924 and July 1926, France had ten Ministers of Finance and seven governments. The tide turned in what came to be known as the “Poincaré stabilisation.” On 23 July 1926, the right-centre government of Raymond Poincaré was sworn in. Poincaré served as his own Finance Minister and immediately went about reversing the course – higher taxes and lower spending. Poincaré cut the highest income tax rate from 60% to 30% and instead raised tax on consumption with the explicit aim of encouraging entrepreneurship and encouraging the French to repatriate capital they had parked abroad to escape from high taxes and the crisis of 1924-26. Poincaré’s policies produced the necessary change in expectations and the Franc recovered.

This hard-won stabilisation and the resolve to not repeat mistakes of the past, set a belief in French policymakers to prevent any return of inflation. Therefore when France started accumulating gold, it sterilized the inflows – which led to a contraction of the money supply in the gold standard system. France’s share of world gold reserves soared from 7% in 1926 to 27% in 1932 (chart below). By 1932, France held nearly as much gold as the US, although its economy was only about a fourth of the size. Together, the US and France staggeringly held more than 60% of the world’s monetary gold stock in 1932. As Economist Douglas Irwin put it – “if the United States and France had been monetizing the gold inflows that would have been playing by the “rules of the game” of the classical gold standard. Then the gold inflows would have led to a monetary expansion in those countries, just as the gold outflows from other countries led to a monetary contraction elsewhere. Both France and the United States were effectively sterilizing the inflows to ensure that they did not have an expansionary/inflationary effect.” The stockpiling drained everybody else of gold, and consequently made staying on the gold standard impossible. The US and France had to eventually abandon it as well, in order to reverse years of deflation.

Share of World Gold Reserves

Source: Douglas Irwin (2010), “Did France cause the great depression?”

British economist John Maynard Keynes could not resist this biting remark: “And, when the last gold bar in the world has been safely lodged in the Bank of France that will be the appropriate moment for the German Government to announce that one of their chemists has just perfected the technique for making the stuff at 6d. an ounce.”

Isn’t it fascinating we see the same orthodoxy in Europe this time albeit on the fiscal policy front with Germany the driving force? It just reminds you that history does repeat itself, only the characters are different.

Markets and the Economy

New British Prime Minister Boris Johnson has promised to negotiate a “do or die” Brexit deal and ensure the UK leaves the European Union (EU) by October 31. I am sure Johnson will live beyond Halloween even if he were to fail to deliver on his promise. However, what is not in doubt is that populism is here to stay. Not just in sound bites, but increasingly in actions on the ground. The Brexit Party, led by Nigel Farage, scored a stunning victory in the recently concluded election for the European Parliament. It’s not difficult to comprehend that if Boris Johnson were to fail in his endeavour to deliver a “clean Brexit”, his government would fall and the backlash could deliver a Brexit party government lead by Farage as Prime minister or indeed that of another populist Jeremy Corbyn heading a coalition of Labour, Liberal Democrats, Scottish Nationalist Party (SNP) and the Green party. The evidence on populism from France is, according to a recent survey, French military personnel are surging in numbers to support Marine Le Pen and the National Rally (RN). Things are not great in Germany either. Economic growth is down, manufacturing numbers are at seven years low (and getting worse) and unemployment is rising (albeit from a low base). Germany’s domestic intelligence agency estimates that there are now some 12,700 far-right activists in the country who are “ready to use violence.” Another reason for the mounting concern is the likelihood that far-right extremists have contrived to infiltrate the police, the armed forces and even the spy agencies in Germany.

Last week the ECB talked about “potential new asset purchases,” and a “rate cut”. i.e. everything is on the table for its September meeting.

Just a reminder that the balance sheet as a % of GDP stands at 18% for the Fed and a huge 40% for the ECB. Yet, the ECB wants to restart QE and buy more assets! What should worry savers in the Eurozone is that negative interest rates are not temporary – but are here to stay. This is financial repression and any hope of a turnaround for savers is now a mirage. The ECB’s deposit rate, already at -40bps, is likely to be cut more at its September meeting. So far negative deposit charges are being levied on deposits over €500k only and therefore the lack of a popular rebellion against such financial repression – but that may change.

What happens when the deposit rate is cut from -40bps now to say -80bps as things get worse? How long will banks resist and not charge their depositors and continue to bear the cost of the levy they have to pay on their own deposits at the ECB? Data indicate that Germans savers have parked just under € 2.5 trillion in checking accounts. With a current inflation rate of +1.6%, German savers are losing €40 billion in purchasing power every year. This is besides not making any money on deposits or in some cases paying for the privilege of keeping the money on deposit. At the press conference last week, Mario Draghi, the ECB President, warned that the picture is getting “worse and worse,” in the Eurozone.

Turning to the markets and taking a look at the performance numbers. The S&P 500 index (SPX) is still holding on to a stellar +20% return for the year. European equities are recovering too now that the ECB is back into an easing mode and doubling down on both rate cuts and additional QE. Nobody doubts that the incoming ECB President Christine Lagarde will follow an easy money policy path set by her predecessor. The question is – the Eurozone already has an easy money policy (rates -0.40%). How much easier does it have to get?

If the Eurozone’s challenges could be solved by rate cuts and/or bond-buying alone, then the bunting would be out and folks would be celebrating in the streets of Paris, Berlin, Madrid and Athens. The Eurozone has had near-zero or negative rates for 5 years now and things haven’t improved much (if any). However, one shouldn’t trade against the announced policies or intentions of a central bank. Therefore, if the ECB follows easy money policy as announced, one has no option but to buy European equities and particularly the Eurozone banks which will end up getting help from the ECB in the not so distant future.

Benchmark Equity Index Performance (Year-to-Date)

As the chart below, from analysts at JP Morgan, indicates the negative yield on bonds in the Eurozone is getting worse. Deutsche Bank research indicates that 43% of the global ex-US Investment Grade (IG) Index is trading at negative yields at the moment, up from 20% late last year. As if to underscore the point on negative yields, last month we learnt that Germany sold a new 10y German government bond (Bund) with no coupon. Think about it for a minute – a bond that pays NO coupon, and promises to return to the investor €100 in 10 years time is trading at €104.5 i.e. the investor is guaranteed to lose €4.5 on this investment. Of course, regulations and risk weightings mean that the pension funds in the Eurozone have no choice but to invest in these loss-making “safe assets.” Another way to look at it – Pension funds in the Eurozone are being robbed. If this continues (and the signs are it will), soon Pension funds will be meeting their pension commitments from capital rather than from returns on capital, as they should be doing. If you and I did it, we would be apprehended for running a Ponzi scheme. The longer the yields remain negative, the more Ponzi the whole thing becomes. The Eurozone needs urgent reform. We live in hope.

Whether we get another rate cut in the US later this year or not, monetary policy will remain on the easy path and the Fed will not raise rates anytime soon. Therefore, I feel very comfortable holding on to long US equity positions. This type of stimulus could eventually result in a bubble, but until the manufacturing and housing sectors stop weakening and inflation starts firming up, there is little to be worried about. If growth in China and the Eurozone trends up, helped by a stimulus in their respective economies, then the future is bright for corporate earnings.

I like to be long the cyclical sectors at this stage – Financials (XLF), Consumer Discretionary (XLP), Energy (XLE) and Industrials (XLI) in particular. Cyclical stocks have had a bit of a mixed run of late but have been outperforming since the end of May sell-off. Semiconductors have broken out to highs and are likely to continue heading higher. The fact that Industrial stocks have risen despite falling Purchasing Managers Index (PMI) numbers globally indicates that the global economy is bottoming out. Individual stocks in the Technology (XLK), Communication Services (XLC) and Materials (XLB) sectors also offer good upside. For specific stock recommendations, please do not hesitate to get in touch.

Here are few other statistics to bear in mind. If we take the time between the first rate cut and the next rate hike as a cycle, since 1982 there have been fourteen such cycles:

  • Of the 14 cycles, only on three occasions, the SPX has had negative returns. The average annualized return for the SPX during those fourteen cycles has been +20% (median +13%)
  • The length of the cycle on average was 571 days (longest 3,011 days, shortest 31 days, median 180 days)
  • So if one were to take median data into account – then one would not expect a rate rise for at least 6 months (if not more) and by the time the rate rise comes the SPX would have risen to 3,360 or better (that is up +13% from current levels)
  • After the 1995 Fed pause, it should be noted that Emerging Markets, as well as the Technology and Financials sectors were the biggest winners

Best wishes,

Manish Singh, CFA

 

“Never confuse a single defeat with a final defeat.”

Summary

Last week, in an extraordinary interview US President Donald Trump embarked on a vicious and personal attack on the US Federal Reserve Chairman Jerome Powell. Trump ranted – “Here’s a guy – nobody ever heard of him before. And now, I made him, and he wants to show how tough he is, okay. Let him show how tough he is.” In recent times, Trump’s attack on the Fed has intensified. Meanwhile, Powell has the challenge of navigating three distinct challenges – setting a policy to prolong the 10-year-old economic expansion, explaining clearly why the Fed adopts the policy it does and ignoring the most consistent badgering of a Fed Chair by a US President in the recent memory. I do not expect the Fed to yield to political pressure and any interest rate cut will be in response to weakening economic conditions and not due to name-calling and bullying by Trump. While Trump started on the right track by promising to change the way the US is governed, I now believe it may have just been lip service and he will do whatever it takes to get himself re-elected.

The market is pricing in significantly lower interest rates to come and this should be seen as an early indication of a growth slowdown in the US economy. The Fed raised rates in 2018 by a full 100 basis points, yet the 10-year yield curve didn’t steepen, but flattened instead. The yield curve fell sharply in Q4 2018 and continues to fall. It reminds me of the 2005-06 rate hike cycle, when the Fed raised rates and kept raising, even as the yield curve was flattening fast and financial conditions were tightening. By the time the Fed started cutting rates, it was too late, the US economy had tipped into a recession. I expect the Fed has learned from its past mistakes, and it appears that the Fed is listening this time around. The Fed paused interest rate hikes in December last year, adapted its communication significantly to make it more dovish and is now getting ready to cut rates. This bodes well for risk assets and will help keep the recession shallow when it eventually comes.

Trump at 15,000 roentgen

If you haven’t yet seen Chernobyl – the Sky/HBO series retelling the catastrophic 1986 explosion at the nuclear reactor in Chernobyl, Ukraine – then I strongly recommend you do so. The mini-series has proven such a compelling watch, that over a quarter million users of the influential entertainment website Internet Movie Database (IMDb) have rated the show, as the best television series of all time. The series is visually pleasing as it recreates the daily life in the Union of Soviet Socialist Republics (USSR) in the 1980s and stars, amongst others, Jared Harris as flawlessly cynical nuclear physicist Valery legasov and Emily Watson as the clinical and committed nuclear physicist Ulana Khomyuk, trying to discover the cause of the explosion. It is so well made and so detailed that you leave thinking you’ve just earned a PhD in nuclear physics.

Chernobyl isn’t just an account of a nuclear catastrophe. It illustrates what happens to societies when lies become mainstream and people stop questioning them. In scene after scene, Communist party officials decreed that the incident is not serious. In one particular scene, an engineer who oversaw the safety test that led to the disaster says to the scientist trying to find out what happened the night of the accident – “Do you think the right question will get you the truth? There is no truth. Ask the bosses whatever you want and you will get the lie. And I will get the bullet.” The lie travelled up the Party’s chain of command and the truth was lost with disastrous consequences. The Communist party retained monopoly on power and thus, by extension, a monopoly on “information” and “truth.” Chernobyl helped destroy the Soviet Union. Mikhail Gorbachev, Soviet Union’s last General Secretary described the explosion as a “turning point” that “opened the possibility of much greater freedom of expression, to the point that the system as we knew it could no longer continue. Gorbachev’s attempted to re-inject life into the moribund Soviet system by introducing reforms such as Glasnost (listen) and Perestroika (openness), but to no avail, and the Union ultimately collapsed in 1991. The dosimeters at Chernobyl were calibrated to register a maximum reading of 3.6 roentgen (400 chest X-rays every second). We later learn the real levels were as high as 15,000 roentgen.

Scene from HBO’s critically acclaimed mini-series Chernobyl

Source: Liam Daniel/HBO

This brings me to the main topic of my newsletter this month. It will not surprise you that US President Donald Trump continues to play fast and smooth with facts. However, of late, he is hitting 15,000 roentgen (if not more) on the outrage dosimeter. Last week, in an extraordinary interview with FOX Business anchor Maria Bartiromo, Trump embarked on a vicious and personal attack on the US Federal Reserve (Fed) Chairman Jerome Powell, Trump ranted – “Here’s a guy — nobody ever heard of him before. And now, I made him, and he wants to show how tough he is, okay. Let him show how tough he is. He’s a– he’s a– he’s not doing a good job.”

Trump went on to say that he has “the right” to demote or fire the Fed chair – which is not true. The US President may choose not to reappoint the Fed chair for a new four-year term, but the President can’t fire him mid-term. Trump also went on to say “we should have Draghi instead of our Fed person. Draghi, as you know, last week he said lower interest rates and we’re going to stimulate the economy…and with us we have a Fed that keeps raising interest rates.”

This attack follows from another attack last week when Trump called into a CNBC news program and complained about the Fed’s policy under Powell. Trump said – “They made a big mistake. They raised interest rates far too fast. It’s more than just Jay [Jerome] Powell. We have people on the Fed that really weren’t—you know, they’re not my people.”

In recent times, Trump’s attack on the Fed has intensified. If I were to list them all I would run out of pages. Below are some of the most recent ones.

  • “If the Fed had done its job properly, which it has not, the Stock Market would have been up 5000 to 10,000 additional points, and GDP would have been well over 4% instead of 3%.” – Trump on Twitter, April 14
  • “Despite the unnecessary and destructive actions taken by the Fed, the Economy is looking very strong” – Trump on Twitter, April 4
  • “The only problem our economy has is the Fed. They don’t have a feel for the market….. The Fed is like a powerful golfer who can’t score because he has no touch–he can’t putt!” – Trump on Twitter, December 24, 2018
  • “I’m doing deals, and I’m not being accommodated by the Fed. They’re making a mistake because I have a gut, and my gut tells me more sometimes than anybody else’s brain can ever tell me.” – President Trump in a Washington Post interview, November 27, 2018
  • “The Fed is going wild. I mean, I don’t know what their problem is, but they’re raising interest rates and it’s ridiculous. The Fed is going loco and there’s no reason for them to do it.” – Trump in a Fox News interview, October 10, 2018

In 2016 when Trump was running for President, he accused then Fed Chair Janet Yellen of not being “independent” and “cutting rates” because US President Barrack Obama told her to do so. He accused the Fed of having created a “false stock market.” The Dow Jones Index was at the 18,000 level then. It is at 26,500 now. That was the false stock market, and this isn’t?

The world is no stranger to Trump’s cantankerous tweets, interviews and extemporaneous remarks criticising his political opponents and adversaries in the media. He is of course entitled to hold an opinion on where interest rates should be. However, to make the attacks on the Fed Chair is most astounding. I am by no means saying that the Fed is right and Trump is wrong, and that economists are better than politicians when it comes to monetary policy. In fact, the growing number of economists with PhDs in economics at the Federal Reserve should be a sign of concern. The Harvard Business Review (HBR) published an article on it – “How Economics PhDs Took Over the Federal Reserve.” During the term of President Harry Truman, the Federal Reserve employed three economists with doctorates in economics. Today, there are more than 700 economists with doctorates employed there. The Fed should never lose sight of real business and the real world and should be careful of not getting too academic with so many PhDs around with “ivory tower” mind-sets and theoretical thinking. All said and done, I’d still chose Powell’s economics over the “Gut Economics” of stable genius Trump. Trump obviously fancies his chances of winning the Nobel Prize, not just for peace but the economics as well.

Meanwhile, Powell has the difficulty of navigating three distinct challenges – setting a policy to prolong the 10-year-old economic expansion, explaining clearly why the Fed adopts the policy it does and ignoring the most consistent badgering of a Fed Chair by a US President in the recent memory.

Before Trump, the last President to publicly call for lower interest rates1 was George H.W. Bush during his re-election bid in 1992. Bush later blamed then Fed Chair Alan Greenspan for his election defeat and said – “I think that if the interest rates had been lowered more dramatically that I would have been re-elected President because the [economic] recovery that we were in would have been more visible. I reappointed him [Greenspan], and he disappointed me.”

I do not expect Powell to yield to political pressure and any rate cut will be in response to weakening economic conditions and not due to name-calling and bullying by Trump.

On the US-China trade deal, there have been so many claims and counter-claims by Trump’s White House, that nobody knows anymore where the deal is or what’s going to be made of it. Last week, CNBC reported that the – “White House says Trump and Chinese President Xi Jinping are going to meet at the G20.” However, they qualified it by saying that they are not going to take the White House’s word for it and would believe it when they hear it from the Chinese. Now, depending on which side of the Trump debate you are on, you could say that the CNBC is no fan of Trump or you could say that they are tired of Trump’s lies and don’t trust anything coming out of the White House. Either way, it’s extraordinary to think that the Chinese news service is trusted more to confirm the news of a meeting between the US President and the Chinese President. The destruction of truth is a wound that doesn’t heal quickly.

Trump’s popularity however among his base is still high. The Trump base believes he is doing a great job. That tariffs are working, that the US economy is on a strong footing and that the US is winning the trade war. While Trump started on the right track by promising to change the way the US is governed, I now think he will do whatever it takes to get himself re-elected i.e. his term will not put the US back on the right track and that the lies will damage America a great deal. It reminds me of Hannah Arendt’s famous observation – “If everybody always lies to you, the consequence is not that you believe the lies, but rather that nobody believes anything any longer.” Trump may be just a symptom of a society gone very tribal and unwilling to consider troubling truths.

In my opinion, sadly, the US (and much of the Western world) is in midst of its own Chernobyl and is suffering from a collapse of the traditional family unit and its effect on demographics, civic and interpersonal engagement – giving way to life in a virtual world, crippling and rising inequality, monetary policy of artificially low rates that benefit small section of the society at the expense of the rest, a breakdown in political consensus which has been so vital in ensuring growth and progress in the post-war period, and the media’s complete abrogation of its duty of objective reporting or semblance of it.

Markets and the Economy:

The S&P 500 Index (SPX) saw another V-Shaped recovery this month, as the -6.5% sell-off witnessed during May, is on course to be recouped. Talk of an interest rate cut by the Fed has intensified. The recent escalation of US-China trade tensions has fuelled worries about a sharper growth slowdown in the US. A weak May jobs report in the US has further added to the concerns. At the recent Federal Open Market Committee (FOMC) meeting, the Fed left interest rates unchanged, but raised expectations for a rate cut – or two – in the near future.

The word “patient” was removed from the FOMC statement in favour of language promising to “closely monitor the implications of incoming information for the economic outlook.” The text of “closely monitor” in the statement has preceded rate cuts in 2007 and 2000. The market is, therefore, pricing in a 100% probability of a rate cut at the July 31 meeting of the FOMC. I believe that we will see a +0.25% rate cut at the next FOMC meeting irrespective of the outcome of the US-China meeting at the G-20 in Japan.

Benchmark Equity Index Performance (Year-to-Date)

Source: Bloomberg

Parts of the US yield curve have been inverted since last November and now the key 10 year – 3 month Treasury yield curve is inverted. While not all US yield curve inversions have led to a recession, a yield curve inversion has preceded every US recession since World War II and slowing economic data in the US should not be ignored. The Fed, therefore, will not be complacent and will cut rates to smoothen the economic slowdown that will inevitably follow after a decade of economic expansion. A rate cut, or a series of rate cuts, might just prolong the expansion by a few more quarters. The Eurozone, the UK, Switzerland, and Canada also all have inverted yield curves, at shorter maturities.

The market is pricing in significantly lower interest rates to come and this should be seen as an early indicator of the growth slowdown in the economy. The Fed raised rates in 2018 by a full, 100 basis points, yet the 10-year yield curve (USGG10YR) didn’t steepen but flattened instead. The yield curve fell sharply in Q4 2018 and continues to fall (chart below).

US 10-Year Treasury Yield and Fed Funds Rate

Source: Bloomberg

It reminds me of the 2005-06 rate hike cycle, when the Fed raised rates and kept raising even as the yield curve was flattening fast (chart below) and financial conditions were tightening. The Fed kept the rates at +5.25% level all through June 2006 to September 2007, even as the yield curve inverted in August 2006. By the time the Fed started cutting rates, it was too late, the US economy had tipped into a recession. The US entered a recession is December 2007 with the Fed Funds Rate still at +4.25%. Sensing that it was lagging behind, the Fed embarked on a set of very aggressive rate cuts and in the next 3 months, cut rates by a whopping 225 basis points.

US 10-Year Treasury Yield, Fed Funds Rate and S&P 500 Index

Source: Bloomberg

I expect the Fed has learned from its past mistakes, and the need for it to act pre-emptively. It appears that the Fed is listening this time. The Fed paused interest rate hikes in December last year, adapted its communication significantly to make it more dovish and is now getting ready to cut rates. This bodes well for risk assets and will help keep the recession shallow when it eventually comes.

Source: Bespoke Premium

Meanwhile, in Europe last week, European Central Bank (ECB) President Mario Draghi signalled the bank could embark on a new round of stimulus as soon as next month, sending the EUR/USD lower and prompting an unusual rebuke from Trump.

Trump tweeted: “Mario Draghi just announced more stimulus could come, which immediately dropped the Euro against the Dollar, making it unfairly easier for them to compete against the USA.”

Draghi said that in the coming weeks the ECB would consider how to adapt their policy tools “commensurate to the severity of the risk” to the economic outlook. He added: “We have our remit, we have our mandate. We are ready to use all instruments that are necessary to fulfil the mandate.” The instruments being – extending the time frame before the next interest rate increase, a reduction in the already negative policy rate or restarting bond purchases.

The Eurozone has long had a trade surplus with the US and that surplus now stands at a record high of €139 billion (up from €119 billion in 2017). Trump has long disliked this surplus and repeated his scathing attack on Europe ahead of the G20 meeting in Japan saying “it [Europe] treats us worse than China.”

Trump also added that the “European nations were set up to take advantage of the United States. They have worse trade barriers than China,” and expect Trump to turn his ire on the Eurozone in a not so distant future and respond with his favourite tool – tariffs – on auto exports.

Given the Fed is getting ready to cut rates, equities will remain well bid, but I do not see the SPX moving beyond the 3,000 level on a sustained basis. What the Fed rate cut expectation does is put a floor under the SPX. I expect the SPX to trade in a narrow range of 2800-2950 for the next few weeks. There will not be a sustained sell-off in US equities as the “Powell Put” and “Trump Put” are still in place. The opportunity, therefore, lies more in sector rotation and buying the sectors that have been lagging this year – Financials (XLF), Energy (XLE) and Industrials (XLI) in particular. Individual stocks in the Technology (XLK), Communication Services (XLC) and Consumer Discretionary (XLP) sectors also offer good upside.

Source: Bespoke Premium

With the ECB in the easing mode, European stocks and the Eurostoxx 50 Index (SX5E) offer a good short term buying opportunity. Emerging Markets should also perform well given the scenario of a US rate cut that will have a dampening effect on the US Dollar vis-à-vis Emerging Market currencies. I would wait for the outcome of US-China meeting at the G-20 before adding risk. If this relationship deteriorates further, then markets would see a sharp sell-off and would offer a good buying opportunity into what would most certainly lead to a rate cut by the Fed at its July 31 meeting.

For specific stock recommendations, please do not hesitate to get in touch.

1 Greenhouse, S. (1992, June 24). BUSH CALLS ON FED FOR ANOTHER DROP IN INTEREST. The New York Times. Retrieved from https://www.nytimes.com/1992/06/24/business/bush-calls-on-fed-for-another-drop-in-interest.html

Best wishes,

Manish Singh, CFA

 

“If you don’t design your own life plan, chances are you’ll fall into someone else’s plan. And guess what they have planned for you? Not much.”

Summary:

President Donald Trump has diagnosed the China threat to US dominance correctly, but the remedies are too late. In my opinion, the US lost the “trade war” to China over a decade ago, as successive US Presidents – Clinton, Bush, Obama sold America short by giving in to corporate greed and abandoning the “nationalist” cause, which had served America so well for over two centuries. I am afraid the current generation of US leaders will find out that trade advantages are gained over years of meticulously planned policy-making and initiatives and not claimed or given away in a deal. The world is witnessing a new Cold War – a Technology war – and both China and the US are digging in for a long fight. At stake is technological and military superiority and the dominance of the global economic system. Of course, this version of the Cold War is very different from the last one fought between the US and the Soviet Union. The Soviet Union was just a military power and not the economic power that China is. Unlike China, the Soviet Union had little influence or trade links outside the socialist bloc of nations. I suspect the US-China trade war will escalate further.

Meanwhile at the US Federal Reserve (Fed), the big concern still seems to be that inflation expectations could become fixed at uncomfortably low levels, relative to the +2% target. The most recent data indicates that the Fed’s preferred inflation gauge – the core Personal Consumption Expenditures (PCE) rose just +1.6% in March from a year earlier, down from +1.8% in January and +2% in December. In recent interviews two District Fed Presidents – James Bullard and Charles Evans, have intensified their call for a rate cut, should inflation remain lacklustre. What this means is that there will be no sustained sell-off in US equities.

My Way or the Huawei

The US-China trade war has escalated and has become a case of He said, Xi said. President Trump, in an interview with Fox News on Sunday claimed that the US and China “had a very strong deal” but “they [China] changed it”. Chinese President Xi’ Jinping’s spokesman, on the other hand, said: “We don’t know what this agreement is the United States is talking about”, pouring cold water on Trump’s claim that there ever was a deal to be done and China reneged on it. The truth of the matter is that this is not a fight about trade. This is a fight by the US to protect its global interests and influence from the onslaught of the Chinese juggernaut, which over the last decade has become a formidable force of economic and political influence, technological innovation and a major global investor.

In my opinion, the US lost the “trade war” to China over a decade ago as successive US Presidents – Clinton, Bush, Obama sold America short by giving in to corporate greed and lobbyists and abandoning the “nationalist” cause which had served America so well for over two centuries. In her book ‘The Rich and How They Got That Way,” Cynthia Crossen uses an anecdote to make her point on how America lost its way in the 20th century as wealth replaced gods, armies, and the family as the altar around which society determined and exalted its values.

Once a very rich man consulted a psychiatrist for the first time. “I have everything a man could want,” the man complained. “Great wife, kids, health, four homes, servants, my own vineyard, a young girlfriend who used to be an acrobat.”

“My dear man,” interrupted the doctor, “you should be very happy.”

“Happiness, happiness,” the patient moaned. “What is happiness? Can it buy money?”

Trump has diagnosed the China threat to US dominance correctly but the remedies are too late. I am afraid the current generation of US leaders will find out that trade advantages are gained over years of meticulously planned policy making and initiatives and not claimed or given away in a deal. The US, rather late in the day, is making a valiant attempt to shoe-horn China and stop its relentless rise. The US-China trade spat, therefore, has moved on from accusations and tariffs to the US imposing a formal ban on American and even foreign companies from doing business with China’s Huawei Technology, the world’s second largest smartphone maker. Huawei’s growth is impressive if you consider the fact that it is largely locked out of the US market, and up until the trade war, was a largely unknown mobile brand in the West. Huawei’s global procurement totals around US$67 billion a year. That’s a lot of revenue that US companies will now miss out on.

The world is witnessing a new Cold War – a Technology war – and both China and the US are digging in for a long fight. At stake is technological and military superiority and the dominance of the global economic system. We received early signs of China’s preparedness in the wake of the US ban on Huawei. This report in The Nikkei newspaper indicates, Huawei anticipated the ban and started stockpiling crucial components more than six months ago. Stockpiling was not limited to semiconductor chips alone but spanned a wide range of electronics, including passive components and optical parts. At the beginning of the year, Huawei also started certifying more suppliers of semiconductor chips, optical components, camera-related technologies and other parts in places outside the US.

The world is witnessing a new Cold War – a Technology war – and both China and the US are digging in for a long fight.

Of course, this cold war is very different from the last one fought between the United States and the Soviet Union. The Soviet Union was just a military power and not the economic power that China is. Unlike China, the Soviet Union had little influence or trade links outside the socialist bloc of nations. Trade between the United States and the Soviet Union peaked at $4.5 billion in 1979. The Soviet Union continuously ran a trade deficit with the US. By contrast, China as the world’s largest manufacturer and exporter, occupies a central position in the global supply chain. China has been the world’s largest exporter of goods for over a decade now and last year, its exports totalled over US$2.2 trillion. China’s total trade with the US last year was US$737 billion. China has run a trade surplus with the US for well over 30 years. China is the world’s second largest recipient of foreign direct investment (FDI) behind the US. Over 70,000 US companies have invested over US$265 billion in China. Chinese counterparts have US$140 billion of investment in the US.

S&P 500 Index and VIX (last 12 months)

Many in the US (and indeed the West) still hold the dangerously naive view that China is home to “cheap and cheerful” copycat items. Huawei leads in 5G patents and Chinese smartphones now account for over 40% of global sales from less than 5% in 2012. While China is rolling out the 5G technology, not just in China but abroad, the US risks falling behind at home. There are only five companies with a reliable and proven ability to provide 5G services, none of them American. As this article in The Vergeindicates, 5G is still just hype for US telecom companies Verizon and AT&T. Delayed rollouts, limited hardware tests, conflicting standards, and political wrangling indicate that the mess of 5G will only get worse in the US as the rollouts continue. No wonder the UK approved Huawei’s 5G technology roll out in the UK and other European countries are doing the same, despite US warnings. 5G promises to be – “the first network built to serve the sensors, robots, autonomous vehicles and other devices that will continuously feed each other vast amounts of data, allowing factories, construction sites and even whole cities to be run with less moment-to-moment human intervention,” according to the national security reporters at The New York Times. Any nation without a suitable and reliable alternative to Huawei will be foolish to ban Huawei and imperil its own future economic prosperity.

As things stand, the probability of a grand deal is greatly reduced and suspicion will only grow. China will go full steam ahead with its “Made in China 2025” industrial policy to the annoyance of hawks in the United States Trade Representative (USTR). You can be sure that a new operating system to rival Google’s Android and Apple’s iOS is in an advanced stages of development. Google and Apple are at greatest risk from Huawei. Amazon and Microsoft not so much. China is an important market for Apple. A Huawei smartphone with its own operating system is a game changer. Not only does it hurt Apple sales in China, but it also eats into Android’s market share. The Huawei operating system would most certainly be banned in the US but not necessarily in Europe. According to one estimate, China will be importing $30 trillion of merchandise and $15 trillion of services over the next 15 years. Europe, which has a large export-driven economy, will do everything to get a good chunk of that China demand for merchandise and services, even if it displeases the US.

The US has accused China of unfair trade practises, economic espionage and government links. If you are a student of history and international trade or take great interest in it, you will know how hypocritical such claims are. The reality is that all successful nations have copied technology and methods be it Britain, France, Italy, Germany, the US, Japan, Korea and now China. China copying US technology, therefore, is not in some way unique but a continuation of what’s been happening for hundreds of years. As historian Doron Ben-Atar observes in his book “Trade Secrets” – “the United States emerged as the world’s industrial leader by illicitly appropriating mechanical and scientific innovations from Europe.” America was the China of the 19th Century.

Samuel Slater, often called “the father of the American Industrial Revolution” emigrated to the US in 1789 but not before he had “stolen” the secrets of textile mills from England. Slater brought with himself an intimate knowledge of the leading British inventor (and a leading entrepreneur during the early Industrial Revolution) Sir Richard Arkwright’s spinning frames that had transformed textile production in England.

The efforts of Thomas Digges, America’s most effective industrial spy was praised by President George Washington for “activity and zeal.” While sending one consignment, Digges proudly reported to US Secretary of State Thomas Jefferson that “a box containing the materials and specifications for a new Invented double Loom” was about to depart to America. The US government often encouraged such piracy. US Treasury Secretary Alexander Hamilton, in his 1791 “Report on Manufactures,” called for an aggressive policy of technology piracy and the need to reward those who brought to the US “improvements and secrets of extraordinary value” from elsewhere. Only a constant influx of immigrants, later on, lessened the necessity for the US to recruit skilled artisans in Europe. Although US federal patents were supposed to be granted only to people who came up with original inventions, Ben-Atar shows that, in practice, Americans were receiving patents for technology pirated from abroad.

Not that the British didn’t have a long history of piracy themselves. The most famous of course was the Great British Tea Heist of 1848, when Britain’s East India company sent botanist Robert Fortune on a trip to an area in China forbidden to foreigners, in order to steal the secrets of tea horticulture and manufacturing. Although the concept of tea is simple – dry leaves infused in hot water—the manufacture of it is not intuitive at all. At the time of Fortune’s visit, the recipe for tea had remained unchanged for two thousand years, and Europe had been addicted to it for at least two hundred of them. This great robbery allowed the British to grow tea in India, breaking China’s stranglehold on the market and paved the way for the renewed prosperity of Britain after it had lost the US colonies. There are many such instances in history – the French trying to steal the technology of James Watt’s steam engine, the Japanese copying from the Americans, the Koreans taking from the Japanese and the Americans etc.

The Culture and Preparation of Tea, China (1843), by English artist Thomas Allom

I suspect as the US-China trade war escalates further, China will impose many restrictions on US companies operating in China, and it could easily start with Boeing. China is slated to surpass the US as the world’s biggest aviation market by as early as 2022 and Boeing predicts China will need more than 7,200 new aircraft worth over US$1 trillion in the 20 years through 2036. Unlike the US case against Huawei of “engaging in illegal activity” which is yet to be proven, Boeing has proven to be dangerous to air passengers. China could ban the Boeing 737 MAX from China’s airspace even after the Federal Aviation Administration (FAA) approves it to fly again. This will have a knock-on effect, discouraging airlines from other countries with regularly scheduled flights into China from buying the Boeing 737 MAX, if they still want to operate in China’s airspace. The US may retaliate by refusing to sell aircraft parts to China. Europe’s Airbus will only be too happy to step in and sell aircraft and aircraft parts to China.

A fair and a compromise deal takes time to agree unless emergencies arise.

A trade deal is never about one side wins all. A fair and a compromise deal takes time to agree unless emergencies arise. Trump has already pivoted on some of the key trade issues with the EU, Japan, Canada and Mexico. Last week he lifted tariffs on metal imports from Canada and Mexico while delaying for six months tariffs on autos from the European Union and Japan. Right now, perhaps, the only possibility of a fair deal is sometime next year when Trump really focuses on re-election and burnishes his “deal-making” credentials by signing a compromise deal with China and declaring victory.

Markets and the Economy:

Given the overhang of the US-China trade war, equity markets have not fared well this month. You will recall, in last month’s newsletter,  I recommended to “take profits” on any long positions ahead of an anticipated slowdown in May and the elevated levels reached by the equity markets. The US equity market had its strongest first-quarter in more than two decades, as we witnessed a V-shape in the S&P 500 Index (SPX) –  from 2900 to 2400 and then back over the 2900 level during a 7-month period from October to April.‎

The US equity indices have fared better than the Emerging Market indices ( see table below), except for India where Prime Minister Narendra Modi has now secured a fresh 5-year mandate, in a landslide victory in the recently concluded national elections. Modi’s National Democratic Alliance (NDA) won more than 350 seats, far above the 272 required for a majority in India’s lower house of Parliament. I expect Modi to double down on reforms and accelerate growth even further. India will be a key market for investors to focus on in the years to come. India is the fastest growing G-20 nation and, this year, is forecast to become the world’s fifth largest economy, surpassing the UK, behind only the US, China, Japan and Germany. The International Monetary Fund (IMF) expects India’s Real GDP to grow by +7.3% and +7.5% in 2019 and 2020 respectively – the highest of any G-20 nation.

Benchmark Equity Indices Performance (year-to-date)

Given that the trade war is spreading and the prospect of a quick deal is reduced, there will be little conviction among market participants to be long the SPX beyond the 2900 level. Therefore, strategies that monetise income are my preferred way of trading such markets. Please reach out to your Crossbridge Capital contact to find out how to invest in such income strategies.

At the US Fed, the big concern still seems to be that inflation expectations could become fixed at uncomfortably low levels, relative to the Fed’s +2% target “if inflation did not show signs of moving up over coming quarters,” according to minutes released this week. The most recent data indicates that the Fed’s preferred inflation gauge – the core Personal Consumption Expenditures (PCE) which excludes the volatile food and energy categories, rose just +1.6% in March from a year earlier, down from +1.8% in January and +2% in December. Even though the minutes revealed no discussion of a rate cut at the meeting, in recent interviews two District Fed Presidents –  St. Louis Fed President James Bullard and Chicago Fed President Charles Evans have intensified their call for one, should inflation remain lacklustre. Bullard remarked that the Fed may need to cut rates even if the economy wasn’t slowing, “to help maintain the credibility of the [Fed’s] inflation target going forward”, and Evans said persistently low inflation “is justification for deciding that our setting of monetary policy is actually restrictive and we need to make an adjustment downwards.”

What this means is that there will be no sustained sell-off in US equities as a Powell Put and Trump Put are in place. The opportunity, therefore, lies more in sector rotation. I continue to advocate buying the recent weakness in the Financial sector (XLF), Industrials (XLI) and Consumer Discretionary (XLY) and to reduce holdings in Technology (XLK) and Communication Services (XLC), in anticipation of the tech war between the US and China getting worse before getting better.

US Equity Sectors Performance (year-to-date)

Meanwhile, in the Eurozone, both growth and inflation continue to look dire, even as the negative interest rate policy, introduced as a temporary measure by the European Central Bank (ECB) has now run for 5 years. Based on current data and evidence, the ECB’s deposit rate is likely to stay at -0.4% for at least another 18-months and possibly through 2021. A low or negative rate threatens pensions, creates real-estate bubbles and doesn’t fully quell the spectre of deflation. It also disadvantages the banks who struggle with weak interest income and thin margins on loans, therefore, making it harder for them to finance any economic growth. As if that were not enough, pain already for an economy struggling to get better, populism is on the rise. In the European Union (EU) elections taking place this weekend, the EU-sceptics are set to gain more leverage. According to projections by opinion-polling company Kantar, the EU-sceptic parties could win up to a third of the seats in the EU Parliament. This would force centrist pro-EU groups to form a three or even four-way coalition, complicating even further the EU’s cumbersome decision-making process. The EU is about to enter into a long period of stalemate in decision making. I, therefore, continue to be underweight European equities.

Some thoughts on the recent tech IPOs and particularly, Uber. So is it 1999 all over again or is it worse?

It’s too soon to say how this recent set of IPOs will end up, given the amount of liquidity in the market, but it is worth looking at the recent round of tech IPOs and compare them to 1999. The differences first:

  • The companies debuting now are far bigger and far older. According to research by Jay Ritter of the University of Florida, the median age for tech companies going public in 1999 was four years. It is 12 years today. Amazon went public in early 1997, just three years after Jeff Bezos founded it in his garage
  • The median sales then were about $12 million compared with $173.6 million today

And the similarities of the Class of 2019 with their predecessors from 20 years hence? They’re all still losing money (chart below).

On its second day as a public company, UBER’s stock slid -11% to $37.10 placing it -18% below the IPO price of $45 (UBER has since recovered to $40.5).

Let’s look at UBER’s journey, which was founded ten years ago:

  • Uber has raised over $24bn in funding to date
  • Uber has amassed operating losses in excess of $12bn
  • Uber’s loss in the 12 months through March 2019 rose to more than $3.7bn, by far the largest ever for a US start-up in the year before an IPO
  • IPO documents show UBER lost $1bn on $3bn in sales in just the past three months

I often hear this refrain from Uber bulls – “In its early years, Amazon lost money too. Uber is another Amazon just wait and see.” So let me point out that, Amazon lost $3bn in its first seven years (1996-2002). Uber lost more than than in the past nine months alone.

More importantly, however, loss-making companies rely on “growing” revenue to become profitable i.e. spreading the “fixed cost” over a larger revenue. I fail to see what Uber’s “fixed cost” is ? The trouble with Uber is that most of its costs are “variable”. The cost, therefore, rises with each $ of revenue it makes i.e. more trips do not translate to higher profitability.

Besides, ride-sharing apps are only growing in numbers and competition is fierce. Yesterday, I downloaded a new ride-sharing app which advertises itself as – the ride-hailing app that takes care of its users. Well, it did take care of me, as I paid only £4.15 for a journey from Mayfair to Chelsea. To do my research, I struck a conversation with the driver. I found out that the driver was getting paid £20 bonus for this journey beside his fare. So the company is making £4.15 and paying out nearly £25 pound? I wonder how long this can continue. The driver was very candid and said that as soon as the bonus period is over, he will leave and move on to the next new app.

Such discounts and promotions used by tech companies to ramp up sales at any cost are a little like the negative deposit rates in the Eurozone. It was only ever meant to be used sparingly but the patient became addicted. The way to make money in the current tech IPO craze is to invest in the early rounds when the company is still private and ride the valuation high. IPO’s then become the exit point and not the point from which prices ramp up. Uber in its IPO document warned that it “may not achieve profitability.” I’d take that warning very seriously.

For specific stock recommendations, please do not hesitate to get in touch.

Best Regards,

Manish Singh, CFA

 

“Nothing makes a man so adventurous as an empty pocket.”

Summary:

As markets tumbled in December, the US Federal Reserve (Fed) realised the errors of its hawkish stance and decided to change tune. In January, the Fed confirmed a pause in interest rate hikes and an end to its balance sheet normalization this year. In March, Fed Chair Jerome Powell doubled down on the Fed’s dovish stance, signalling no hikes in 2019 and an end to the balance sheet reduction by September. As a result, the US equity market had its strongest first-quarter in more than two decades. When it comes to market recoveries from a correction, they don’t get much more V-shaped than the last seven months. I wouldn’t say that the Fed is a “hostage of the market” for I firmly believe that the Fed will raise rates if US inflation were to accelerate. However, a “Powell Put” – a reference to Fed Chairman Jerome Powell and the Fed’s sensitivity to equity market selloffs – is firmly in place. South Korea’s economy unexpectedly contracted by -0.3% in the first quarter, the worst in a decade.  It doesn’t bode well for other manufacturing and technology exporters such as Germany, Japan and Taiwan. It also means that the Fed will be under little pressure (if any) to raise interest rates this year.

Earlier this month, India kicked-off its general election, the results of which will be declared on May 23. Polls indicate that current India Prime Minister Narendra Modi is likely to return to power – albeit with a reduced majority – and may have to rely on like-minded allies to form a government. Regardless of the outcome, India will be a key market for investors to focus on for years to come. India is the fastest growing G-20 nation and, this year, is forecast to become the world’s fifth largest economy, surpassing the UK, and behind only the US, China, Japan and Germany. As China’s growth decelerates and labour costs rise, investors are beating a path to the doorstep of India to take part in its middle-class growth story. By the end of the 2020s the number of households active in India’s consumer economy will have grown to 312 million – that’s the size of Germany, France, UK, Italy and Spain all put together.

Who let the doves out?

On Tuesday this week, The S&P 500 index (SPX) had its highest closing on record, breaking past its previous record set on September 20, 2018 (see chart below). The SPX has surged by over +16% this year and up +24% from its December low. Yet, things were looking so different in Q4 last year when the SPX fell by nearly -20% from early October to Christmas. US recession fears, a hawkish Federal Reserve, and the end of the equity rally were the talk of the day. As the VIX – the measure of the stock market’s expectation of volatility – soared, doom and gloom were predicted for the equity markets.

In my November Newsletter, I wrote: “I do not see a US recession on the horizon. The US economic cycle has further to run and US consumers, in particular, remain strong. The sell-off, therefore, represents a buying opportunity for global stocks”. The SPX fell further and in my December Newsletter, I wrote “ …despite the news of a yield curve inversion at the front end (2 year and 5 year), I put the probability of a recession in the US next year at very low. The US economy is set to grow at over +2% rate in 2019. This leaves a window for equities and other risk assets to show renewed strength given the recent sell-off.” Here we are now with all that equity sell-off behind us and an all-time high on the SPX, the DOW Jones Industrial Average (DOW) and the NASDAQ!

So, who let the doves out? The Fed, of course.

In December 2018, the Fed raised the Federal Funds Rate and signalled another two hikes in 2019, as well as continued to unwind its balance sheet at the rate of up to $50 billion per month – even as US economic data started showing signs of a slowdown. However, in January, as markets tumbled the Fed realised the errors of its hawkish stance and changed its tune, to confirm a pause in the rate hikes and an end to its balance sheet normalization this year. In March, Fed Chair Jerome Powell doubled down on the Fed’s dovish stance, signalling no hikes in 2019 and an end to the balance sheet reduction by September. As a result, the US equity market had its strongest first-quarter in more than two decades. Also helping was renewed optimism around the US economy, which still shows signs of expansion. When it comes to market recoveries from a correction, they don’t get much more V-shaped than the last seven months (see chart below). Rising stocks have been accompanied by a sharp drop in stock market volatility. VIX – the so-called “fear index” – is down more than -50% this year (see chart below).

S&P 500 Index and VIX (last 12 months)

Source: Bloomberg

I wouldn’t say that the Fed is a “hostage of the market” for I firmly believe that the Fed will raise rates if US inflation were to accelerate. However, a “Powell Put” – a reference to Fed Chairman Jerome Powell and the Fed’s sensitivity to equity market selloffs – is firmly in place.  Add to this, the widely perceived “Trump Put” – US President Donald Trump’s sensitivity to a move down in US equity prices as well as the “Xi Put” – China’s President Xi Jinping’s sensitivity to China’s GDP growth tracking at least at the 6% level or a stimulus package would ensue.

Can the rally continue?

I don’t see any signs yet of the Fed bringing an end to this rally. A US recession or inflation acceleration also look distant at the moment. However, given the strength of the rally in equities this year it may be prudent to take profit and reduce long positions in anticipation of “Sell in May and go away” playing out this year – a well-known adage that warns investors to divest their stock holdings in May to avoid a seasonal market decline and then wait to reinvest in November. The phrase is thought to originate from an old English saying, “Sell in May and go away, and come on back on St. Leger’s Day” and refers to a custom of the English aristocrats, merchants, and bankers who would leave the City of London and escape to the country during the hot summer months. St. Leger’s Day refers to the St. Leger’s Stakes, the oldest of England’s five horseracing classics and the last to be run held on the second Saturday of September. Stock market return patterns have supported the theory behind the adage. According to the Stock Trader’s Almanac data – since 1950 the DOW has had an average return of only +0.3% during the May-October period, compared with an average gain of +7.5% during the November-April period. Health warning – please bear in mind what happened last year. The “Sell in May and go away” approach would have cost you dearly last year, as the SPX continued to move higher from May to September and had a steep sell-off in November and December. Caveat Venditor!

India goes to the polls

On April 11, India kicked-off its general elections for its 543 parliamentary seats. Nine-hundred million Indians are eligible to vote. The sheer scale of the operation means the election will run over seven-stages and last just over a month. The results will be declared on May 23. Incumbent Prime Minister Narendra Modi and his Bharatiya Janata Party (BJP) are seeking a second term in power, with a campaign that has revolved largely around – national security, economic development, relief for farmers and welfare measures targeted at reducing poverty. In 2014, Modi and his BJP party secured a spectacular victory and won a rare absolute majority to form the national government. For three decades, prior to elections in 2014, India’s voters refused to give any single political party a majority in Parliament. A coalition government was the order of the day, with an associated lack or slowness of crucial reforms.

Will the 2019 election see a return to a coalition government or a return of Modi with another majority government?

Polls indicate Modi is likely to return to power, albeit with a reduced majority and may have to rely on like-minded allies to form a government. Regardless of the outcome, India will be a key market for investors to focus on for years to come. India is the fastest growing G-20 nation and this year is forecast to become the world’s fifth largest economy, surpassing the UK (see chart below), behind only the US, China, Japan and Germany.

India is the fastest growing G-20 nation and, this year, is forecast to become the world’s fifth largest economy, surpassing the UK, and behind only the US, China, Japan and Germany.

India, UK Gross Domestic Product (in millions USD)

Over the last decade, India’s Gross Domestic Product (GDP) has grown at an average rate of +7.2% per annum. As a result, the budget deficit (as % of GDP) over the same period has fallen from a giddy -6.5% to the current level of -3.4%. Inflation in the same time period has fallen from over +10% to less than +3%.The International Monetary Fund (IMF) expects India’s Real GDP to grow by +7.3% and +7.5% in 2019 and 2020 respectively – the highest of any G-20 nation.

Even as inflation has fallen, the budget balance improved and GDP grew, curiously but understandably, the yield on Indian government bonds, has not narrowed over the last decade and instead has gone up from +6% to +7.5%. This is because the current account balance (as % of GDP), has stayed in deficit and is currently at -2.4%. This deficit has put pressure on the USD/INR exchange rate, as India needs to earn USD from exports to pay for its Oil imports. India is the third biggest importer of crude oil behind China and the US. India’s Oil import bill at $115bn, is nearly 30% of its foreign exchange reserves. Compare that to China, whose Oil import bill, at $240 billion, is only 7% of its foreign exchange reserves. Unlike China, India’s exports have not kept pace with its GDP growth. GDP growth has necessitated increased oil imports and hence greater need for foreign exchange reserves to pay for them. Unless India grows its exports (or strikes oil domestically that cuts the oil import bill or sees a sustained surge in Foreign Direct Investment which brings in USD), the yield on Indian sovereign bonds will stay elevated. India’s total exports for 2018 at $292 billion pales in comparison to China’s $2.4 trillion. As growth accelerates, India’s Oil bill will only grow and put downward pressure on the Indian currency.

Despite that, as China’s growth decelerates and labour costs rise, investors are beating a path to the doorstep of India to take part in its middle-class growth story.  As the chart below from Gavekal indicates – by the end of the 2020s the number of households active in India’s consumer economy will have grown to 312 million – that’s the size of Germany, France, UK, Italy and Spain all put together.  Within this total, the number of emerging consumer households in India will double from 71 million to 141 million. Aspiring households will triple from 32 million to 101 million. And the number with incomes above the affluent threshold will leap almost four-fold from 18 million to 71 million.

A positive outcome in the elections – a majority government with a focus on continued reform and a fiscal policy stance which improves domestic credit conditions and therefore increases capital expenditure – will see the Indian equity  markets rally substantially. With the USD strength waning, the external environment looks supportive for investment in India in particular and Emerging Markets in general.

Markets and the Economy:

We have talked about US equities and my views on them remains constructive as does my view on Emerging Markets. The “take profit” recommendation is only tactical and being overweight the US v/s the Rest of the World is still the equities trade to be in. This morning, poor economic data out of South Korea, one of Asia’s biggest exporters will raise questions about global trade. South Korea’s economy unexpectedly contracted by -0.3% in the first quarter, the worst in a decade.  This doesn’t bode well for other manufacturing and technology exporters such as Germany, Japan and Taiwan. It also means that the US Fed will be under little pressure (if any) to raise rates this year. The S&P 500 index therefore is unlikely to correct much as rate cut expectations will keep it bid

Benchmark Equity Indices Performance (year-to-date)

The Financial (XLF) and the Healthcare (XLV) sectors, which have lagged the SPX, offer good opportunity to rotate into from the Technology (XLK) and Communication Service (XLC) sectors which have rallied a great deal.

US Equity Sectors Performance (year-to-date)

European financial stocks are attractive so long as the narrative from the European Central Bank (ECB) remains supportive. Negative interest rates, as we currently witness in the Eurozone, effectively means that banks pay the ECB to park their excess liquidity with it overnight. A tiered deposit rate would relieve banks from paying the 0.40% annual charge on a portion of their excess reserves, thereby boosting their profits.

I expect the current Italian government to fall soon after the European Union (EU) elections and for Matteo Salvini to be the sole PM as the LEGA party and its allies win the next general election. Brussels spent valuable time arguing about Italy’s deficit target, when not just Italy but the EU as a whole should have focused on policies that promoted growth. To make matters worse, Rome will need to find almost €23 billion of savings to avoid a hefty increase in Value-Added Tax (VAT) which is scheduled to kick in unless the government finds alternative measures. A VAT increase would only see resentment and populism rise. The Bank of Italy sees Italy’s 2020 budget deficit at -3.4% without a VAT hike. One can safely assume that the deficit will be at -4% by the end of 2020 given the serious lack of growth plans in Italy or in the Eurozone. Italy is a serious risk for the EU to deal with. This, when the engine of the Eurozone – Germany – is grinding to a halt. The German Finance ministry has halved the official 2019 German GDP growth forecast to only +0.5% ( it was at +2.1% this time last year). The German business group, BDI, said recently, “The best times for the economy are over.” This will be the weakest German GDP expansion in six years. It is time for Germany to start spending some or all of that 2% budget surplus. That will be good for the whole of Eurozone. However, will they?

A few thoughts on China. China’s GDP grew at a better than expected +6.4% in the first quarter of this year. While this has buoyed risk appetite in stock markets globally, and many see it as a game changer, I don’t.  One has to look at broader data coming out of China. Here is one – China land sales revenue growth collapsed to -33% in 1Q (see chart below) from +11.8% in 4Q18. The biggest drop since the financial crisis of 2008.

Land sales accounted for roughly half of the local governments’ total revenue sources in 2017 and it is perhaps still around 30% of fiscal revenue for local governments. While monetary policy will continue to be accommodative, the deleveraging agenda—curtailing shadow banking and excessive local government borrowings, will remain a top priority of Xi Jinping’s government. As long as the State Owned Enterprise’s (SOE) and local Government’s finances improve or get on a solid footing, Beijing will hold back on stimulus and stay the course on deleveraging even if it means accepting lower growth targets. The US-China trade deal is unlikely to conclude before June and the market seems to have accepted this so long as the talks continue and no new fears arise. Understandably, the negotiations are tenuous given this is no simple trade deal. Expect China to continue with a stop-and-start-stimulation process that helps meet its GDP growth target of +6%. Over stimulation, which can help particularly the moribund Eurozone economy is not on the agenda. The US and Europe will have to rely on their own growth. While the US and China are headed towards a compromise, Trump has a major decision to make about auto import tariffs and it is very likely the “New NAFTA” can’t pass Congress (at least not until after the Nov 2020 election). So headlines on EU-US tariffs are going to soon dominate the news. The EU has a weak hand to play but the EU mandarins secured in their “ivory tower” in Brussels hardly ever care about a “weak hand” or, for that matter, “realism.”

For specific stock recommendations, please do not hesitate to get in touch.

 

Best Regards,

Manish Singh, CFA

“Democracy, in this late stage of capitalism, has been replaced with a system of legalized bribery. All branches of government, including the courts, along with the systems of entertainment and news, are wholly owned subsidiaries of the corporate state. Electoral politics are elaborate puppet shows.”

Summary:

The Brexit negotiations are in limbo because UK Prime Minister Theresa May is not only absolutely convinced her deal is the right deal, but she is also convinced that the UK must not leave the European Union (EU) without a deal. On the other hand, the EU doesn’t want to re-open the Withdrawal Agreement and remove the backstop that would ensure the passage of the deal in the House of Commons. Additionally, the EU is not prepared to deal with the consequences of a UK exit from Europe, and is therefore only too happy to extend the article 50 deadline with the hope of getting the UK to change its mind and not leave. A third Meaningful Vote is in doubt. What is not in doubt in my mind, is that if Theresa May were to lose this vote, her fate would be sealed and she will be out of 10 Downing Street. A new leader and a general election could follow in quick succession as Brexit is delayed. In my opinion, the events of last week have raised the probability of a no deal, be it now or indeed after a general election. Recent polls indicate that public opinion against a delay to Brexit, and leaving with no deal if need be, is hardening.

Elsewhere, when investors hear the words, yield curve inversion, they automatically think, recession. This is because every recession in the US since 1962, nine in all, has been preceded by such an inversion. However, it is also worth remembering that not every inversion has been followed by a recession and that the lag between an inversion and an ensuing recession has lasted anywhere from 7 to 24 months, with an average of 14 months.

Mañana

Another European Union (EU) council meeting has come and gone. The Brexit deadline has been pushed back. The annoying Brexit countdown clock on Sky News has been rendered useless and reset. The answer to – “When will Brexit be resolved?“ 1005 days after the referendum, continues to be mañana. Last Thursday, over a three-course dinner of green lentil terrine with langoustine, roast duckling a l’orange and chocolates, UK Prime Minister Theresa May and the EU 27 came up with a solution which can only be called a fudge – the UK will leave on May 22, if the UK Parliament backs May’s Brexit deal. If the deal is voted down, Britain will have until April 12 to pick between no deal and agreeing to hold European elections in return for a longer extension to the Article 50 process. May has categorically rejected the idea of the UK taking part in European elections, at least for now. The Meaningful Vote – or MV for short, now stands for May’s Vanity. She has no support for it in the UK Parliament and on Monday the parliament voted by 329 to 302 – a majority of 27 – for a cross-party amendment to enable MPs to stage a series of “indicative votes” on alternatives to the Prime Minister’s deal. It is hoped that the “indicative votes” would result in one option, securing the support of a Commons majority. However, it’s also possible that, ultimately, Parliament fails to coalesce around a single option, and we end up back where we started.

A baffled Swiss journalist was quoted in the Daily Telegraph asking – “My country is a democratic country. We always enact the result of our referendums. We greatly admire your country [UK], especially your House of Commons. Please, can you explain why it is refusing to enact what the people decided? Your MPs who do this seem to us to be enemies of the people”. I am afraid the Swiss reporter is spot on. It is very odd that the result of the largest democratic vote in the history of the UK should be so rudely fudged and every effort spent by an overwhelmingly “Remain” Parliament to delay or only partially implement the result. The disconnect between MPs and the people has been in the open since the referendum took place. While the country, by parliamentary constituency, voted 406 to 242 to leave the EU – a surplus of 164, MPs voted 486 to 160 to stay, a deficit of 326. This disconnect is the biggest obstacle to getting Brexit resolved and only a general election can narrow the Leave vs. Remain gulf in the House of Commons. I see no other way of achieving this.

The Brexit negotiations are in limbo because May is not only absolutely convinced her deal is the right deal, but she is also convinced that the UK must not leave the EU without a deal.

The Brexit negotiations are in limbo because May is not only absolutely convinced her deal is the right deal, but she is also convinced that the UK must not leave the EU without a deal. On the other hand, the EU doesn’t want to re-open the Withdrawal Agreement and remove the backstop that would ensure the passage of the deal in the House of Commons. Additionally, the EU is not prepared to deal with the consequences of Brexit and therefore is only too happy to extend the article 50 deadline in the hope of getting the UK to change its mind and not leave the EU. The Eurozone Purchasing Managers Index (PMI) Index for manufacturing numbers out last week makes grim reading and indicates that the region is teetering on the brink of recession, as a manufacturing slump in Germany and France – its two biggest economies- shows no signs of abating. A no deal Brexit, in such a circumstance, would only make the Eurozone’s problems worse.

Purchasing Managers Index (PMI) Index for Manufacturing
Purchasing Managers Index (PMI) Index for Manufacturing
Source: Bloomberg

The PMI number for Eurozone (MPMIEZMA in the chart above) fell to 47.6 in March, from 49.4 in February. This index was at 60.6 back in December 2017. A reading below 50 indicates a contraction. France’s business activity in both services and manufacturing (MPMIFRMA) is now also in contraction zone. Meanwhile, Germany’s vast manufacturing industry shrank at the quickest rate in more than six and a half years. Germany Manufacturing PMI (MPMIDEMA in chart above) slumped to 44.7 in March, from 47.6 in February. The index was at 63.2 back in December 2017. UK’s manufacturing PMI (MPMIGBMA), however, is at 52, despite Brexit, but you wouldn’t know that from the Brexit scare stories that UK’s media love to report.

In my opinion the events of last week have raised the probability of a no deal, be it now or indeed after a leadership change in the Conservative party, which looks all but inevitable. Recent polls indicate that public opinion against a delay to Brexit and leaving with no deal, if need be, is hardening. Don’t be fooled by the #PeoplesVoteMarch. London voted overwhelmingly to Remain in the EU and organisers should try holding the next march up North and see how many from London are committed enough to travel up there to march for Remain. I never thought I would agree with any of the marchers until I saw this banner…”Ikea has better cabinet” with which I wholeheartedly agree. Both the Tory Cabinet and the Labour shadow Cabinet are a disgrace, to put it politely. Of course, a no deal outcome will send everyone scurrying to find a new deal and may be the only way to resolve the stalemate and establish a forward-looking trading relationship between the EU and the UK.

A third Meaningful Vote could still take place later this week, if May thinks she will not lose again. The 10 MPs of the Democratic Unionist Party (DUP) have opposed the Withdrawal Agreement in both previous votes and their “position remains unchanged.” What is not in doubt in my mind is that if Theresa May were to lose the third Meaningful Vote, her fate would be sealed and she will be out of 10 Downing Street. A new leader and a general election could follow in quick succession, as Brexit is delayed.

US-German relations at a breaking point

Ever since US President Donald Trump was elected, US-German relations have been frayed and may have now reached a breaking point. The US has pushed North Atlantic Treaty Organization (NATO) members to pay their dues, threatened Germany with crippling tariffs on its auto exports to the US, opposed Germany’s Nord Stream 2 gas pipeline project – a new natural gas pipeline through the Baltic Sea to supply Russian gas to the key EU market, and warned against purchasing Chinese 5G technology from Huawei, that US administration officials believe could present a security threat.

In recent months, Berlin has rebuked Washington’s demands that Germany limit purchase of gas from Russia, ban Huawei from its 5G network, and prevent German companies from doing business with Iran. Germany is now poised to renege on its pledge to meet NATO’s defence spending target. Last year, German Chancellor Angela Merkel publicly pledged to increase German military expenditure to 1.5% of GDP by 2024. However, the spending plans outlined by the German Finance Minister Olaf Scholz last week, will see German defence spending drop well below the 2% Gross Domestic Product (GDP) by 2022. By comparison the US’s defence budget for 2019 is $686 billion, approximately 3.5% of GDP. US ambassador to Germany, Richard Grenell remarked – “NATO members clearly pledged to move towards, not away, from 2% by 2024. That the German government would even be considering reducing its already unacceptable commitments to military readiness is a worrisome signal to Germany’s 28 NATO allies.”

And if Germany hadn’t defied the US enough already, Berlin, instead of countering China and its Belt and Road Initiative (BRI) making inroads deep into the Eurozone, is now embarking on a summit meeting between EU heads of Government and Chinese President Xi Jinping next year. Germany holds the EU presidency from July to December 2020. The Chinese have bought into the Greek port of Piraeus and are eyeing the development of the Atlantic container port of Sines in Portugal. In Italy, ports like Trieste and Palermo are also of interest to China.

The Economist Group Limited, London (2 July 2016)
Source: The Economist Group Limited, London (2 July 2016)

As Germany pushes the EU to seek a closer relationship with China and warms up to Russian gas, sceptics will say Germany has forgotten the sound of Soviet tanks rolling across the German mud. However, Germany has urgent concerns of its own. For the last two decades, Germany has relied heavily on its industrial exports to China and in particular auto exports to the whole world. With the auto sector hitting peak growth, the decline in production impacts the whole auto-sector supply chain – from chemicals to plastics, rubber and auto ancillary. Given Germany’s dominance in manufacturing and auto sector supply chain, it is one of the worst affected and in Q4 last year German economy escaped a technical recession by the skin of its teeth. Last year, Chinese imports from Germany fell by -37%. Besides an improving US-China relation also means China buying more from the US in order to shrink its trade deficit with them. China buying more from the US means China buying less from the rest of the world. The size of China’s local market and the ensuing demand means Germany has no option but to seek a better and closer relationship with China to support its own export-oriented economy until such time that Germany can reduce its dependency on exports by stimulating its own domestic growth and that of the Eurozone. However, that will be a slow process and it is fraught with risks.

China buying more from the US means China buying less from the rest of the world.

To make matters worse Europe and Germany have fallen behind in 5G mobile internet technology. The 5G mobile internet connectivity promises much faster data download and upload speeds, wider coverage, more stable connections and increased capacity. The 5G technology is expected to officially launch across the world by 2020, when Europeans will become painfully aware of the shortcomings in innovation policy in their telecommunications. China’s Huawei is a leader in 5G technology and therefore Germany has refused to ban them despite the pressure from the US. Merkel reiterated that her country would instead tighten security rules. “Our approach is not to simply exclude one company or one actor”, she told a conference in Berlin recently, “but rather we have requirements of the competitors for this 5G technology”. Banning Huawei without the availability of an alternative will handicap Germany in the technological industrial revolution that is playing out.

Markets & Economy

While the S&P 500 (SPX) is meeting stiff resistance at the 2820 level, equity returns so far in 2019 have been very impressive. One quarter into 2019, Year-To-Date (YTD) the SPX index is up +11.6%, Europe’s flagship index, Euro Stoxx 50, is up +10.6% and MSCI Emerging Market Index is up +8.5% (table below).


The yield curve inversion – when the yield on long-term debt drop below its shorter-term (chart below) caused quite a stir last week and saw a sharp sell-off in the equity markets towards the end of the week, this despite a very dovish US Federal Open market committee (FOMC) meeting which left the Federal Fund Rate between +2.25% and +2.5% and indicated that it may not raise rates further this cycle.

Source: Bespoke Investment Group (B.I.G)
Source: Bespoke Investment Group (B.I.G)

Normally, the yield differential between short term debt and long-term debt, would be an upward sloping line. The higher long-term yield reflects the sentiment that growth will continue, and therefore the higher yield for the longer-term debt compensates an investor for the greater risk of inflation that growth will bring and chip away at the real value of the investment. But when the difference between the yield on the short-term debt and long-term debt narrows, it’s a signal that investors are less convinced growth is here to stay. The yield curve therefore first flattens and then inverts.

When investors hear, yield curve inversion, they automatically think, recession. That’s because every recession since 1962 (chart below) has been preceded by a yield curve inversion. However, what is also worth remembering is this – not every inversion has led to a recession (chart below, the shaded region is recession). The San Francisco Fed measured the yield differential between Ten-year and One-year Treasury Notes and the lag between the inversion and the ensuing recession lasted anywhere from 7 to 24 months, with an average of 14 months.

Source: Bespoke Investment Group (B.I.G)
Source: Bespoke Investment Group (B.I.G)

So should we be worried about yield curve inversion and start selling equities?

Certainly not. While the correlation between recession and yield curve inversion is beyond doubt, it’s important to bear in mind that the US Federal Reserve (Fed), as in past yield curve inversions, is not currently raising rates in an attempt to fight inflation. This is for good reason, since inflation remains completely contained and is infact undershooting the Fed’s expectation of +2% p.a. So, much so that they are now thinking of following easy monetary policy for longer to get the inflation higher.

People are taken in by curve inversion too easily. Quantitative easing (QE) has changed everything. Old playbooks are relevant but do not apply. If the Fed wasn’t holding nearly US$ 4-trillion dollars of securities on its balance sheet, where would the 10-year yield realistically be right now? Higher and there would be no yield curve inversion. Therefore, to me, yield curve inversion is a sign of a slowdown in economic growth and not of a recession, at least not in the next 6 months. What the yield curve inversion is really telling us is this – the Fed went too far during the last 12 months in raising rates and a rate cut may not be far enough if the slowdown continues and a US-China trade deal fails to lift growth.

One last thing on US equities. Unless the decline in the SPX continues further, we are about to see a very bullish technical signal at some point this week – the vaunted “Golden Cross.” It occurs when an Index or security’s 50-day moving average crosses above its 200-day moving average, as both moving averages are on the rise (chart below). The upcoming Golden Cross for the SPX would be its first since April 2016. Historical daily return data crunched by the Bespoke Investment Group, indicate that there have been 25 prior Golden Crosses for the SPX dating back to inception in 1928. The returns over the next month, 3 months, 6 months and 12 months after have been positive, with the 12-month return averaging +6.21% after such occurrences.

S&P 500 index: Last 12 Months
S&P 500 index: Last 12 Months
Source: Bloomberg

So, in light of all of the above, my allocation still remains overweight to US equities. I also feel very positive about Emerging Markets (EEM US) as the US Dollar gets weaker versus the EM currencies. While the Chinese tech stocks (Alibaba, Baidu, JD.com) and semiconductor stocks (Micron Technology, Qualcomm, Nvidia) have rallied a great deal over last few weeks, the rally is not done yet. As for US sectors, I like Energy (XLE), Industrials (XLI), Financials (XLF), Communication Services (XLC) and Healthcare (XLV).


Other stocks I like: In terms of stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IBM US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US), Societe Generale (GLE FP), Kering (KER FP), Mastercard (MA US), Lam Research (LRCX US), VINCI (DG FP), Taiwan semiconductor manufacturing company (TSM UN).

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital

“It’s not what you look at that matters, it’s what you see.”

Summary:

At a time when American prestige in the world is fading and China’s status is rising, and as the US and China work to find a mutually acceptable trade deal, it is difficult to imagine how unequal the two nations were in 1979 – the year of the big reforms in China – let alone in 1949 when then Chinese Communist Party leader Mao Zedong established the People’s Republic of China (PRC). In 1979 China’s GDP stood at $178bn and was 6% of US GDP. Today, China’s GDP is 63% of US GDP. For 22 years after the establishment of the PRC, there were no diplomatic relations between the US and China. It was not until April 1971, at the height of the Cold War, that there was the first public sign of warming of relations between Washington and Beijing in what came to be known as “Ping-Pong” diplomacy. When full diplomatic relations were eventually established in 1972, US-China trade stood at paltry $4.7 million, a rounding error when compared to today, and it now stands at $604 billion. The history of US-China relations is a fascinating read and China has gone from being a pariah state to the US in 1949 to its most important trading partner. So much so, that we are heading into a G-2 world where China and the US will make rules for the rest of the world to follow.

The New Year’s rally in equities continues after the US Federal Reserve (Fed) decided to pause its steady campaign of raising interest rates and shrinking its balance sheet. The S&P 500 Index is up over +18% since its December lows and is up +11.1% for the year. The Eurozone’s flagship Index, the EuroStoxx 50, is up +8.6% this year and is set to get a further boost as the European Central Bank (ECB), alarmed by slowdown in growth across the Eurozone, is about to embark on another round of ultra-cheap long-term loans to the banking system. While this new round of monetary policy is not a panacea for the Eurozone, it will boost European equities, particularly European bank stocks, which have floundered since May last year

Chimerica: A G-2 world beckons

The Chinese economy of today is a far cry from the days of Chairman Mao Zedong and the “Great Leap Forward” – his second Five Year Plan which lasted from 1958 to 1963 – and proved a complete disaster for China. It left millions of people dead and many more miserable for decades to come. Frank Dikötter a Dutch historian in his excellent book – “The Cultural Revolution: A People’s History, 1962–1976” – has painstakingly gone through the Chinese Communist Party’s own record and declassified letters of complaint, secret police reports, statistics, surveys and other archived papers, to draw the picture of misery that China was in the 1960s. By Dikötter’s count, the Cultural Revolution – formally the Great Proletarian Cultural Revolution from 1966 until 1976 – left 45 million dead as Mao forced peasants off their land on to co-operative farms and mindless industrial projects. Mao wanted to lift Chinese steel production by putting the whole nation to work at over 600,000 backyard blast furnaces. Instead, he got famine and tens of millions dead. Mao had been warned by then Soviet Union leader, Nikita Khrushchev, that China’s course to industrialisation risked a famine. Khrushchev knew it from his own knowledge of Josef Stalin’s reckless ambition for industrial power that unleashed a famine in Russia in 1932-33 and killed up to five million in Ukraine, a country land rich and fertile for agriculture. Today however, China is the world’s second-largest economy using its wealth to build “colonies” around the world and the only real challenger to US hegemony. This miraculous turnaround achieved in just over 40 years – beginning with the “reform and opening up” of China in 1979 – has led to multiple years of double-digit growth (see chart below).

China GDP Growth Rate (1979-2017)
China GDP Growth Rate (1979-2017)

At a time when American prestige is fading and China’s status is rising and as the US and China work to find a mutually acceptable trade deal and negotiate as equals, it is difficult to imagine how unequal the two nations were in 1979 – the year of the big reforms in China – let alone in 1949 when Mao established the People’s Republic of China (PRC). In 1979 China’s GDP stood at $178bn and was 6% of US GDP. Today, China’s GDP is 63% of US GDP. The history of US-China relations is a fascinating read and China has gone from being a pariah state to the US in 1949 to its most important trade relationship in the world. So much so that we are heading into a G-2 world where China and the US will make rules for the rest of the world to follow. Europe is the big loser in all this and only has itself to blame – no structural reforms, low growth, high unemployment and an over-reliance on exports and not domestic demand.

Europe is the big loser in all this and only has itself to blame – no structural reforms, low growth, high unemployment and an over-reliance on exports and not domestic demand.

Chimerica is a neologism coined by historians Niall Ferguson and Moritz Schularick describing the symbiotic relationship between China and the United States. Yet for 22 years after the establishment of the PRC in 1949, there were no diplomatic relations between the US and China. It was hard and often impossible to get a visa to China, much like for North Korea today. Businessmen were granted access once a year for the Canton Trade Fair. In neighbouring Hong Kong, camera-toting Americans and Japanese tourists would take the bus to go to the border to catch a glimpse of “Red China” on the other side. The relations between the US and China deteriorated to such an extent, that in the spring of 1955, the US threatened a nuclear attack on China in support of its ally – Taiwan. It was not until April 1971, at the height of the Cold War, that there was the first public sign of warming of relations between Washington and Beijing in what came to be known as “Ping-Pong” diplomacy – the US national table tennis visiting China to play their world champion team. Seeing this as an opportunity to open up political relations with China, US President Richard Nixon secretly sent his Secretary of State Henry Kissinger to Peking to arrange a meeting between himself and Chinese Premier Zhou Enlai. The meetings between Kissinger and Chinese officials were successful and the ensuing trip by Nixon to China in February 1972 would become one of the most important events in the world and US post-war history. Nixon called his visit as “the week that changed the world.” Shortly thereafter, the United Nations recognized the People’s Republic of China and granted it a permanent seat on the US Security Council, which had been held by Taiwan since 1945. With this, the inclusion of China in the world order was complete. However, it still took more than a decade before US-China trade relations began to thrive. When full diplomatic relations were eventually established in 1972 US-China trade stood at paltry $4.7 million, a rounding error as compared to today. Between 1980 and 2004, US-China trade rose from $5 billion to $231 billion and it now stands at $604 billion as reported by the United States Census Bureau. The accession of China into the World Trade Organisation (WTO) in 2001 was the defining moment for China and world trade and you can see the seismic shift in China’s GDP since then (see chart below).

World Bank GDP for China and US (in Current USD)
World Bank GDP for China and US (in Current USD)
Source: Bloomberg

US-China trade negotiations are at a crucial stage and, in recent days, US President Donald Trump and US Treasury Secretary Steven Mnuchin have both made positive remarks on the prospects of striking a deal. On Sunday Trump tweeted – “Important meetings and calls on China Trade Deal, and more, today with my staff. Big progress being made on soooo many different fronts”. Talks indicate that both China and the US are focussed on thrashing out a mutually beneficial deal. For instance, Beijing has proposed to increase US semiconductor sales to China to a total of $200 billion – five times the current level. This will help the US narrow its record $384 billion trade deficit with China. Very interestingly, the proposal also indicates moving assembly operations of US semiconductors from countries like Mexico and Malaysia to China. This would allow those products to be counted as US exports rather than those of other countries. What it means is – US and China are reforming the world into a “G-2 world” where their mutual interests will be prime consideration – Trump’s “America First” and President Xi’s “Made in China 2025” (which aims to make China the world leader in cutting-edge technology in ten key industries). The US and China by virtue of their strengths – Technology and innovation for the US, and the size of Chinese domestic market plus the capacity to purchase US Treasury debt for China – put both countries in a position to conclude trade deals which benefit them mutually.

The US and China by virtue of their strengths put both countries in a position to conclude trade deals which benefit them mutually.

As I wrote in the February 2018 Market Viewpoints – “ The world’s two largest economies – US and China have their fates inextricably linked. In a way, they complement and need each other. The US cannot compete with China when it comes to manufacturing and China cannot compete (yet) with the US when it comes to product design or research and development capabilities.” All signs indicate a trade deal will be struck. The March 1 deadline or risk the tariffs on $200 billion of Chinese goods to jump to 25% from the current 10% looks less of a concern. In a statement, the White House press secretary said both sides “have agreed that any commitments will be stated in a Memorandum of Understanding between the two countries.” Recall, in July 2018, the EU and the US agreed to a 392-word statement saying the two sides would work to eliminate tariffs and other barriers and that led to Trump not imposing tariffs on auto exports from the EU. So the memorandum will give room for the US to extend the March 1 deadline to conclude a deal at Trump-Xi summit later in Q2 this year.

Markets and Economy:

The New Year’s rally in equities continues after the US Federal Reserve (Fed) decided to pause its steady campaign of raising interest rates and shrinking its balance sheet. The S&P 500 Index (SPX) is up over +18% since it’s December lows and is up +11.1% for the year (see table below). The Eurozone’s flagship Index, the EuroStoxx 50 (SX5E), is up +8.6% this year and is set to get a further boost as the European Central Bank (ECB), alarmed by slowdown in growth across the Eurozone, is about to embark on another round of ultra-cheap long-term loans to the banking system otherwise known as Targeted Long Term Refinancing Operation (TLTRO). Last week, Peter Praet, the ECB’s Chief Economist, gave the strongest signal yet that more funding could be on the way. He said – “The discussion will come very soon in the Governing Council”. Benoît Cœuré, also a member of the ECB’s decision-making council further boosted the expectation of TLTRO with his comments in New York – “I can see that there is a big discussion in the market of having a new, as we call it, TLTRO. It is possible. We are discussing it, but we want to be sure that it serves a monetary purpose.”

Equity Market Performance (YTD)
Equity Market Performance (YTD)

Regular readers of this newsletter will know my concerns about the Eurozone – politicians paying lip service to structural reforms, as the economy deteriorates and the ECB runs out of tools to help sustain economic growth using monetary policy tools alone. In March 2015, the ECB launched its bond purchases program known as Quantitative Easing (QE). The program was envisaged to run for a year and a half. However, after multiple extensions the program ran for two years longer and only came to an end in December 2018. During this time the Eurozone had its best growth at over +2%. Now that QE has come to an end, Eurozone growth is sputtering again. This has led the European Commission to slash its growth forecast for the Euro area. The EU forecasts GDP in the 19-member Eurozone to grow by +1.3% in 2019 instead of the +1.9% forecast in November. The forecast also indicates that Italy’s economy which slipped into recession at the end of 2018, will grow at the slowest pace at just +0.2% this year. Germany managed to escape recession by the skin of its teeth. The ECB’s balance sheet at over €2.5 trillion is 40% of the Eurozone’s GDP. By comparison the Fed’s balance sheet peaked at $4.5 trillion and now stands at $4 trillion, or 22% of US GDP. While a new round of TLTRO is not a panacea for the Euro area, it will boost European equities, particularly European bank stocks, which have floundered since May last year.

Meanwhile, in the US we got the minutes of the Federal Open Market Committee (FOMC) meeting held on January 29–30, 2019. The minutes indicate most Federal Reserve officials last month were in favour of keeping the Fed’s $4 trillion balance sheet from shrinking further. Fed officials are in favour of releasing an action plan to underscore this point. They believe “such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve’s balance sheet.” This is a confirmation of the about-turn by the Fed officials who, at the December meeting, raised the benchmark rate by +0.25% and pencilled in two rate rises this year, only to change course at the January meeting as the economic outlook turned grey. Many now believe that the Fed is unlikely to raise rates this year. I am of the view however that the Fed will be able to raise rates this year and that raise will come in Q3/Q4 and not sooner. It may seem that the Fed is hostage to the markets and there’s a lot of supporting evidence for this theory. However, I see it more as a communication problem. Fed Chairman Jerome Powell’s communication in December was hawkish in tone but dovish in intent. The market chose to focus on the tone in the press conference and sold-off. This put the Fed on the backfoot to change course soon thereafter.

A weak retail sales number further highlighted softer economic outlook for the US. As the charts below indicate, the -1.2% (month-on-month) decline in December, was the biggest decline since September 2009. Excluding Autos and Gas, the drop was even more dramatic. However, one swallow doesn’t make a summer. If this decline were to continue for a couple more months, then the Fed would be quite concerned and rate hikes would be off the table for the year. I do not however anticipate such a dramatic outcome. The resolution of US-China trade deal, the ongoing stimulus in China, lowered rate rise expectations in the US all combined with +3% p.a. wage growth, point to an economy which is not close to a recession.

Retail Sales Graph
Source: Bespoke Invest

The UK meanwhile, despite the Brexit overhang, is faring well and the recent rally in GBP/USD is indicative of this. Chaining the Quarter-on-Quarter (QoQ) GDP growth for 2018 indicate that UK GDP grew by +1.3% in 2018 (compared to France +1%, Germany +0.7% and the US +3.1%). The International Monetary Fund’s (IMF) GDP growth forecast for the UK for 2019 remains unchanged at +1.5%, while growth in 2020 was revised up by +0.1% to +1.6%. Data released this week indicates that the UK has delivered a record budget surplus in January – £14.9 billion, the largest since records began in 1993. A bumper round of tax receipts helped the surplus climb compared to last January. Borrowing in the current financial year-to-date has nearly halved compared to last year and is 40% lower than the Office of Budget Responsibility’s (OBR) forecast. All very welcome help for a government in case of a No-Deal Brexit. As I have pointed out in last month’s newsletter, I do not expect the UK to leave the EU without a deal.

So, in light of all of the above, my allocation still remains overweight to US equities. I also feel very positive about Emerging Markets (EEM US) and particularly the Chinese tech stocks (Alibaba, Baidu, Tencent, JD.com) and semiconductor stocks (Micron Technology, Qualcomm, Nvidia). As for US sectors, I stay overweight US Financials (XLF), US Communication Services (XLC) and US Healthcare (XLV)

US Equity Sector Performance (YTD)
US Equity Sector Performance (YTD)

Other stocks I like: In terms of stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IBM US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US), Societe Generale (GLE FP), Kering (KER FP), Mastercard (MA US), Lam Research (LRCX US), VINCI (DG FP).

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital

“Regret for the things we did can be tempered by time; it is regret for the things we did not do that is inconsolable.”

Summary:

The realisation is finally dawning on many in Europe that a No Deal Brexit would hit the EU very hard and is therefore an undesirable outcome. After hoping and wrongly presuming that the UK would cancel Brexit (a ludicrous thought that only highlights the gulf in understanding between the UK and the Continent), it is only now – after being convinced of the likelihood of collateral damage in its own country – that Germany is taking a more conciliatory approach. An extension of Article 50 is likely to give enough time to conclude a deal. I see a second referendum as the least likely outcome, with a general election as more likely. Across the pond, it is hard to see a resolution to the US Government shutdown other than President Donald Trump declaring an emergency that would let him reallocate funds that Congress has appropriated for military construction in order to build his wall. Of course, the Democrats will sue him, but at least the government would re-open and both sides could declare victory. US-China trade negotiations are entering a crucial stage and the likelihood of a Deal seems quite high. It is clear that trade wars are not easy to win and Trump is ready to fold, declare victory and focus on getting re-elected. He wouldn’t want China tariffs to be part of the 2020 campaign. China, on the other hand, would be relieved. Meanwhile in Europe, Germany is on the brink of a recession, as it is hit by weaker exports to China and elsewhere, as well as softer demand at home. The Eurozone is in a precarious position. Germany ought to embark on deficit spending and flex the rigid “growth and stability” pact to get the whole Eurozone out of its slow decline. Will they? Don’t hold your breath.

Deal, No Deal or Second referendum?

Last week, Annegret Kramp-Karrenbauer the head of the ruling Christian Democratic Union (CDU) party in Germany and the likely next Chancellor, as well as over two dozen other German luminaries from the fields of politics, art, industry and sport issued a plea to the UK to change its mind and stay in the European Union (EU). The letter published in The Times of London marks a significant shift in Berlin’s tone. It talks about the role of Britain – “we realise that the freedom we enjoy as Europeans today has in many ways been built and defended by the British people” and its continued importance to Europe’s future – “Without your great nation, this continent would not be what it is today: a community defined by freedom and prosperity.” And goes on to implore –“We would miss Britain as part of the European Union, especially in these troubled times. Therefore, Britons should know: from the bottom of our hearts, we want them to stay.”

A bit too late in the day, I’d say. Where were these good people before the referendum in 2016? That was the time for the esteemed leaders of the EU to give then UK Prime Minister David Cameron a worthy deal that he could sell to the British people. Instead, they gave him a bag of crisp hot Brussels air which Cameron tried to present to the British voters as a “great win,” and was repudiated.

EU UK
Source: www.survation.com

The realisation is dawning on many in the EU that a No Deal Brexit would hit the EU very hard and is therefore an undesirable outcome. After hoping and wrongly presuming that the UK would cancel Brexit (a ludicrous thought that only highlights the gulf in understanding between the UK and the Continent), it is only now – after being convinced of the likelihood of collateral damage in its own country – that Germany is taking a more conciliatory approach.

Anyone with any interest in Germany and the EU and where they’re headed, would be well served to read the masterful analysis of the topic in the book Berlin Rules: Europe and the German Way. It is written by Sir Paul Lever, former British Ambassador to Germany and a senior member of the European Commission in Brussels who attended all European Council meetings from February 1979-85. In its institutional form, he suggests that the EU looks and “will continue to look like Germany” and that its “leadership of the EU is geared principally to the defence of German national interests.” His conclusion is that Germany will prevent the creation of the “all-powerful European super-state that ” and in 20 years’ time many (Brits) will have forgotten Britain was ever a member of the EU to make them regret their choice” and “others… may wonder what all the fuss was about.” I recommend the book highly.

Last week also saw UK Prime Minister Theresa May suffer the largest parliamentary defeat in British political history, as the House of Commons rejected her Deal on Europe by 432 to 202 votes. By any yardstick, the defeat that May suffered is entirely of her own making. Tin-eared, distant, and reticent don’t even begin to define the approach she took to agreeing a “Withdrawal Agreement” with an intransigent EU. May couldn’t persuade a starving man to eat with the approach she has taken thus far. Tories must fear a terrible drubbing at the elections, if May continues as PM. Thankfully, she has promised she won’t lead the Tories into the next election.

So, what’s next?

To those who say “No Deal” is off the table or Brexit could be cancelled, I say this – No deal is not “on the table” but it is in the Statute Books. The European Union (Withdrawal) Act 2018 was passed through both Houses of Parliament and became law by Royal Assent on 26 June 2018. 498 of 650 MPs voted to trigger Article 50 i.e. a clear and overwhelming commitment to leave the EU. Over 80% of MPs subsequently were re-elected in 2017 on manifestos pledging to implement Brexit. Legally, in the absence of an agreed deal, the UK, therefore, will leave with “No Deal” on March 29, unless the Article 50 deadline is extended by the mutual agreement of the EU and the UK. A No Deal, however, doesn’t mean “crashing out” as some like to fear monger. It just means agreeing a set of side deals and a temporary return to WTO rules for trading, until new trade deals and arrangements are worked out between both parties.

As I said on Bloomberg TV last week- I still believe that the UK will leave the EU with a deal. An extension of Article 50 is likely to give enough time to conclude a deal. There will be a transition period in which the UK will be part of the customs union and at the end of the transition period, the EU and the UK will move on to a Free Trade Agreement (FTA). As far as the UK is concerned the “freedom of movement” of workers is a red line and will not be up for negotiation.

The EU doesn’t want a No Deal scenario. Nor does the UK for that matter. A No Deal would be very inconvenient for the UK in the short term, as details of new arrangements are worked out, but it would be a growing tragedy for the EU to lose a nation it has a big trade deficit with. Besides a No Deal at, minimum, means:

• Immediate halt to the £39 billion “divorce payment” to the EU
• No further annual contributions of £13 billion to the EU budget
• The EU’s entire exports to the UK – £341 billion last year would be put at risk
• A severe macroeconomic calamity for Ireland

This, at a time when the economic woes of Germany (the driver of the EU 27) are growing as it is hit by weaker exports to China and elsewhere, as well as softer demand at home. A German slowdown is already ringing alarm bells in Brussels and at the European Central Bank (ECB).

EU USA
Source: www.voxEurop.eu

Weaker German growth is very bad news for the rest of the European continent, where many economies are linked to the demands of the German export machine and German consumers. For instance, Germany is France and Italy’s top export destination with 15% of total French exports and 12.5% of total Italian exports going to Germany. A slowdown in Germany would hit France and Italy hard. The possibility of a No Deal or messy Brexit, populism and unrest in France, mounting US protectionism and the slowdown in China all are major headwinds for Germany and the Eurozone. China is Germany’s largest trading partner ahead of the US. If that’s not enough, cast your mind back to last July and the Trump-Juncker conference that temporarily diffused the risk of damaging tariffs on EU auto exports to the US, in return for the EU pledging to work to achieve “zero tariffs, zero non-tariff barriers, and zero subsidies on non-auto industrial goods.”

Fast forward 6 months, and the EU is now being accused by US officials of dragging its feet on trade talks in the hopes of waiting out the Trump administration. It won’t end well if you know what Trump is like. President Donald Trump is about to conclude a trade deal with China. With the Mexico-Canada and China deals completed, all efforts and urgency will go into taking on what Trump likes to call the EU’s “unfair trade deal” with the US that “robs” the US and treats it like a “piggy bank”. Expect fireworks soon.

I see a second referendum as the least likely outcome. A general election is more likely than a second referendum. We know that the country is divided roughly down the middle – half favouring Leave and half favouring Remain. A new referendum will only frustrate those who voted to leave and waste valuable time and resources. Even if there were a second referendum, in my opinion, Leave is likely to win again. In a tweet, Robbie Gibb, Director of Communication at 10 Downing Street reminded us as much – “1.9 million Leave voters say they would now vote to Remain. But 2.4 million Remain voters would now vote to Leave. The country hasn’t changed its mind.” Remember also that the voters were told the Brexit referendum was a “once in a lifetime vote” and 3 years is not a lifetime by any stretch of the imagination. For many in the UK – whether Remainer or Brexiteer, a second vote amounts to a violation of democracy.

As for GBP/USD, the UK economic data on a relative basis is getting better and the US is unlikely to raise rates until the summer given concern about the economic slowdown in the US. Therefore I see GBP/USD getting to 1.32 by June, creeping up to 1.36 or higher by September and 1.40 or higher next year.

Economy & Markets

The US Government shutdown that started before Christmas carries on and is now the longest government shutdown in US history – beating the 21-day clash between President Bill Clinton and the Republican Congress over federal spending that stretched from December 16, 1995, to January 5, 1996. The shutdown is now entering its fifth week and shows no signs of coming to an end. Trump is adamant on getting the $5.7 billion funding he needs to fulfil the campaign pledge to build a wall on the US-Mexico border. Democrats on the other side buoyed by their successes in the mid-term elections, are refusing to grant Trump that money. Democrats insist – reopen the government first, talk later. Trump insists – fund the wall first, reopen the government thereafter. The deadlock continues.

In a televised speech over the weekend, Trump made an important concession – calling for $5.7 billion in funding for the wall in exchange for a three-year protection from deportation for young immigrants illegally brought to the US as children, known as Dreamers. US Senator Chuck Schumer and House Speaker Nancy Pelosi rejected this outright with Pelosi calling it a “non-starter.” Schumer shut down the government in January 2018 for 3 days because protection for Dreamers was not in the budget for 2018. Now he’s refusing to co-operate and open the Government, when the protection for Dreamers is included in this latest offer from Trump. It’s hard to see a resolution other than Trump declaring an emergency that would let him reallocate funds that Congress has appropriated for military construction to build his wall. Of course, the Democrats would sue him, but at least the government would re-open and both sides could declare victory.

Meanwhile, the US government may be shut down, but the markets are off to the races. The table below indicates the stellar run so far in 2019, albeit given the sell-off in December, the rally is still only a comeback or a recovery rally.

EU USA

While Energy (XLE) leads all sectors at +11.3% on the back of crude oil’s +24% surge, Brazil (IBOV) leads all countries in the matrix above with a YTD gain of +11.2%. Remember Energy was the worst performing sector last year down -20.6%.

EU USA

The Q4 earnings reporting period got underway last week in the US. This season couldn’t have started more differently than the last, when investors were selling anything and everything, and it culminated in the S&P 500 index falling off a cliff in December. Less than 100 stocks have reported so far, so there’s still a long way to go. Of those, 69% have beaten consensus analyst estimates (a strong reading) but only 49% have beaten top-line consensus revenue estimates (a weak reading). The revenue beat has been falling for the last four quarters and points to a slowdown in the economy – which is not a bad thing overall, as it will keep the US Federal Reserve (Fed) from raising rates anytime soon.

Recall, the Fed last month raised its benchmark Fed Fund Rate (FFR) by +0.25% to a range between +2.25% and +2.50% and indicated it could raise rates twice this year. At the press conference that followed, Fed Chairman Jerome Powell struck, what the market thought, was a hawkish tone and risk assets promptly sold-off. The sell-off just kept getting worse into the holiday period. Since then, Powell and his colleagues at the Fed have spoken at various forums to allay the worries that the Fed is on a pre-set path. “There is no pre-set path for rates,” Powell said during an appearance at the Economic Club of Washington, D.C. ten days ago. He added – “We’ll take into account tightening financial conditions, which we’ve seen, and we’ll also lower our rate path and try to have monetary policy offset weakness before it even happens.” I do not see a US rate hike until June at least.

US-China trade negotiations are entering a crucial stage and, in recent days, Trump has made positive remarks on the prospects of striking a deal. “I think we’re going to be able to do a deal with China” he tweeted last week. The U.S. and China are seeking to resolve their dispute ahead of a March 1 deadline, when in case of no deal, the tariffs on $200 billion of Chinese goods are scheduled to jump to 25% from the current 10%. In a very positive, and rather surprising turn of events, The Wall Street Journal reported last week that US officials are debating ratcheting back tariffs on Chinese imports, as a way to calm markets and give Beijing an incentive to make deeper concessions in a trade battle that has rattled global economies. This seems a striking turnaround for an administration that hasn’t lifted steel and aluminium tariffs on its closest allies and is still threatening them with a 25% levy on car imports. Treasury Secretary Steven Mnuchin has talked of eliminating the tariffs on $200 billion of Chinese goods and raised the possibility of lifting tariffs on an additional $50 billion of Chinese goods that have been in effect since August. However, Mnuchin faces resistance from US Trade Representative Robert Lighthizer, who is concerned that any concession could be seen as a sign of weakness. In the past, Trump has sided with Lighthizer on tariffs, rather than Mnuchin. But this time, he has made it clear he wants a deal—and is pressing Lighthizer to deliver one, according to people familiar with the discussions. So it seems trade wars are not easy to win and Trump is ready to fold, declare victory and focus on getting re-elected. He wouldn’t want China tariffs to be part of the 2020 campaign. China, on the other hand, would be relieved and of course trade fairly with the rest of the world as soon as it starts exporting of high-quality products – telecom products an example, and Chinese companies start outsourcing cheap labour to other countries. This is pretty much what happened with Japan decades ago, as it went from making “knock-off” products in the 1960 and 70s to innovative new products in the 80s and the 90s and became a world leader in manufacturing.

Meanwhile in Europe, as mentioned above, Germany is on the brink of a recession as it is hit by weaker exports to China and elsewhere, as well as softer demand at home. Germany’s economy shrank in the third quarter of 2018 for the first time since 2015. Germany is one of only a few Western economies to have had huge success exporting to China. It is not only German car manufacturers that are impacted, but some 5,200 German companies operate in China, many of them midsize engineering firms that deliver the capital goods that China has used to power its factories and build its infrastructure. The Eurozone is in a precarious position. Germany ought to embark on deficit spending and flex the rigid “growth and stability” pact to get the whole Eurozone out of its slow decline. Will they? Don’t hold your breath.

So in light of all of the above, my allocation still remains overweight to US equities. I also feel very positive about Emerging Markets (EEM US) and particularly the China tech stocks (Alibaba, Baidu, Tencent, JD.com) and stocks with China exposure (Micron Technology, Apple etc.). As for US sectors, I stay overweight US Financials (XLF), US Communication Services (XLC) and US Healthcare (XLV)

Finally just to remind you about what I wrote in the November Market Viewpoints. Since 1946, there have been 18 midterm elections and US stocks were higher 12 months after every single one. Yes, every single one. That’s 18 for 18. Since 1946, stocks have risen an average of +17% in the year after a midterm election. We’re also in the third year of a presidential term, which is historically the strongest year for stocks. You will note that the performance of stocks in the third year of a presidential term beats all other years by a long shot. Therefore, I recommend you stay long equities.

Other stocks I like: In terms of stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IBM US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US), Societe Generale (GLE FP), Kering (KER FP), Mastercard (MA US), Lam Research (LRCX US), VINCI (DG FP).

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital

“When plunder becomes a way of life for a group of men in a society, over the course of time they create for themselves a legal system that authorizes it and a moral code that glorifies it.”

Summary:

The slowdown in the housing sector, stresses in the leveraged loan market, and low oil prices are all pointing to a more “dovish” hike in interest rates by the US Federal Reserve on Wednesday. A part of me is tempted to say that assuming the Fed raises rates as expected, it is likely to be the last of this economic cycle. But then again, I look at the historically low level of unemployment and also believe that a deal between China and the US will be struck in time, and I am led to conclude that the Fed will still be able to raise interest rates next year. As for the politics of populism, Europe will be the hotbed in 2019. The slowdown in growth in the Eurozone – Q3 GDP growth down to +0.2% (December 2013 level) – doesn’t help one bit in dealing with it. The Gilets Jaunes has already humiliated French President Emmanuel Macron and forced him into an embarrassing climb down that will put a great strain on the French economy. I doubt Macron will recover from this debacle. I expect equities will rise post the Fed meeting this week as the dovish views finally get priced in. The US economy is set to grow at over +2% rate in 2019. This leaves a window for equities and other risk assets to show renewed strength given the recent sell-off. The US economy does not need a tax cut. In fact, a tax cut will be counterproductive and it may overheat the economy, get the Fed to step in and raise rates and cause a recession in 2019.

The Nutcracker

Red cups at Starbucks, a festive range of bags at Marks and Spencer, special window displays on the lit-up and decorated high street – can only mean one thing – Christmas is coming. However, for me, what really signals the arrival of the holidays is the arrival of The Nutcracker. This family-friendly ballet set to Pyotr Ilyich Tchaikovsky’s famous notes “The Nutcracker” originated in Russia. It made its debut at the Marinsky Theatre in St. Petersburg in 1892, a year before Tchaikovsky’s death and is based on “Nutcracker and the Mouse King,” an 1816 story by German author E.T.A. Hoffmann which tells the story of a little girl Clara, her toy nutcracker and their adventure in a kingdom of sweets at Christmas time. The original version was panned by critics and wasn’t performed outside Russia in its entirety until 1934 when Nicholas Sergeyev staged it at the Sadler’s Wells Theatre in London. In the US, ‎The Nutcracker didn’t become popular until 1954 when George Balanchine’s (a Russian-American ballet dancer turned choreographer) production for the New York City Ballet – complete with a Christmas tree rising out of the stage – hit the mark with the audience and an American tradition of watching the ballet at Christmas was born. This ballet has everything – fantasy, love, spectacle and the music is brilliant and familiar because it is out of copyright and therefore has featured in countless advertisements. Some reports suggest that this one ballet accounts for 40-50% of the annual revenues for professional ballet companies.

Ballet
Source: Moscow Ballet (www.nutcracker.com)

Whilst The Nutcracker is a festive treat, what theatregoers don’t realise is that they are watching an important period of history. Russians living in St. Petersburg who saw the ballet for the first time were part of a generation experiencing a level of prosperity never seen before in history. The Industrial revolution had brought rich dividends to Europe and the US, and Russia was very much considered a part of Europe then. The middle class lived in secure and comfortable homes with amenities such indoor plumbing, an electric stove, radio, television, and even hair dryers! It was a time of innovation and prosperity in Europe and the US. The decade that was the 1890s brought forth so many ideas and inventions that the Commissioner of the US Patent Office at the time, Charles Duell said in 1899 -“Everything that can be invented has been invented.” We see hints of prosperity in the opening scene of the ballet‎ – it’s Christmas Eve and Clara and her extended family are hosting a huge Christmas party with an abundance of food, drink and gifts. It symbolises a world that loved globalism and trade. In the ballet, you see foreign delicacies – Spanish hot chocolate, Chinese tea, Arabian coffee and the famed sugar plum fairies, Danish shepherdesses, and of course Russian candy cane dancers along with a beautiful array of fantasy figures. Little did the people then know what was to soon to follow in Russia and in Europe. The happiness, merriment and times of plenty would soon give way to the darker sides of humanity – revolution and war – which would adversely impact the lives of millions.

With populism, protectionism and revolution again in the ascendency, are we in for similar times ahead?

The year 2018 will go down as one of the best in the nine recent years of US economic expansion. The unemployment rate, at +3.7%, remains at a 49-year low. US GDP rose by +3% in Q3 from a year earlier, a rate of growth exceeded in only three other quarters in this expansion that began in March 2009. Inflation reached the US Federal Reserve’s (Fed) target of +2% without overshooting it and wage growth is inching up to +3% (still well below the +4% of past expansions). Meanwhile, in the rest of the world, the year began with most major economies expanding – leading some to think that Europe was going to expand at an even faster rate than the year before. Regular readers of this newsletter will know that – because of its structural problems – I take a very dim view on the Eurozone economy. By the third quarter, output in Germany – the Eurozone’s largest economy – had contracted and the Eurozone is expected to grow at sub +1% rate this year. Japan has also seen a slowdown and as China’s economy and global trade volumes slowed, many Central Banks globally took a step back from sounding hawkish on interest rates.

As the table below shows, this year, the US is a stand out performer in an otherwise miserable sea of red in the world of equities.

Mvp

And to think that everything was going well for US equities – despite the sharp -11% correction in February. The S&P 500 Index (SPX) was up over +9% until early in October, before the narrative of a US-China trade war, Fed interest rate increases, a turn in the economic cycle and a strong US Dollar took a stranglehold on equities. This all resulted in a sharp -14% market sell-off since then (see chart below). Traders and speculators out-manoeuvred investors and it’s been a volatile market ever since.

Mvp
Bloomberg

Markets & Economy

The Fed will conclude its final meeting of the year this Wednesday with markets widely expecting the Fed to raise rates by +0.25%. This will take the Fed Funds Rate to the +2.25% to +2.5% range. However, the slowdown in the housing sector, stresses in the leveraged loan market, and low oil prices are all pointing to a more “dovish” hike on Wednesday. A part of me is tempted to say that assuming the Fed raises rates as expected this week, it is likely to be the last of this economic cycle. But then again, I look at the historically low level of unemployment and also believe that a deal between China and the US will be struck in time, and I am led to conclude that the Fed will be still be able to raise interest rates next year. As per the Fed Funds futures pricing, the most-likely scenario (at a 40% probability) is no change in the Fed Fund Rate for the entire 2019. The likelihood of one rate increase sits at 33% and two hikes at 12%. At the extremes – a rate cut stands at 10.6% and the odds of a repeat of 2018 with more than two hikes is a meagre 2.4%.

In the November 2017 Market Viewpoints, I forecast that‎ the 10 Year yield on US Treasurys would “finish the year in the range +2.85% and +3.0%” and we are at +2.86% currently. For the next year, I forecast that we are going to see, at most, two rate hikes from the Fed and the 10y yield on US Treasurys will finish the year in +3.25% to +3.4% range.

As for the politics of populism, Europe will be the hotbed in 2019. The slowdown in growth in the Eurozone – Q3 GDP growth down to +0.2% (December 2013 level) – doesn’t help one bit in dealing with it. The Gilets Jaunes have already humiliated French President Emmanuel Macron and forced him into an embarrassing climb down that will put a great strain on the French economy. The Bank of France has halved its forecast for France’s GDP growth in Q4 from +0.4% to +0.2% and the deficit is to balloon to -3.4% of GDP (well above the 3% ceiling that the Eurozone nations have to abide by).‎

Recall that Italy’s 2019 planned deficit, which is set to be -2.4%, has been a problem within the EU.

The next recession will tip France over and make its budget a concern for Brussels and a big headache for Germany and the European Central Bank (ECB). I doubt Macron will recover from this debacle. He has lost the trust and confidence of the French people and will have a very hard time to govern going forward.

The French middle class are sick of taxes. The chart below sums up why The Gilets Jaunes have garnered overwhelming support. Hours before the government cancelled its proposed tax rise, a poll conducted for French newspaper Le Figaro showed 78% believed the yellow vests are fighting for France’s general interest.

Mvp

The Organization for Economic Cooperation and Development (OECD) released its annual Revenue Statistics report last week and France topped the charts, with a tax take equal to 46.2% of GDP in 2017. That’s more than Denmark (46%), Sweden (44%) and Germany (37.5%), and far more than the OECD average (34.2%) or the U.S. (27.1%, which includes all levels of government). Macron’s France shows that states can’t support themselves solely with progressive income taxes. More taxes are equal to less progress. France has resisted supply-side reforms for decades and engendered a socialist economy with a few wealth creators paying for the many takers. Now the chickens have come home to roost. Belgium and Netherlands are now seeing their own version of Gilets Jaunes protests.‎

I expect equities will rise post the Fed meeting this week as the dovish views finally get priced in. Since the close on November 8 (the last meeting), the SPX is down over -9%. That’s the biggest decline in between Fed Days since the -8.17% drop between the December 2015 and January 2016 meetings. Recall, that the current hiking cycle began at the December 2015 meeting which sparked a -10% sell-off.

I still recommend an overweight position in equities with a bias to US equities and sectoral bias to – Industrials (XLI), Technology (XLK), Financials (XLF) and Healthcare (XLV). Despite the news of a yield curve inversion at the front end (2 year and 5 year), I put the probability of a recession in the US next year at very low. The US economy is set to grow at over +2% rate in 2019. This leaves a window for equities and other risk assets to show renewed strength given the recent sell-off. The US economy does not need a tax cut. In fact, a tax cut will be counterproductive and it may overheat the economy, get the Fed to step in and raise rates and cause a recession in 2019.

Mvp

The risk of GDP growth is more daunting outside the US and any further tilts to protectionism and nationalism will make matters worse. The backdrop for Emerging Markets (EM) is certainly better given the de-rating relative to the US equities (chart below) and the anticipated reduction in the pace of rate hikes from the Fed. Besides a combination of continued US growth and a modest upturn in the Chinese economy would alleviate many concerns. The result could be a meaningful rally in pro-cyclical EM assets – bonds and equities.

Mvp

I was bullish on floating rate bonds through last year but I do not feel the same now for the reasons mentioned above – fewer rate hikes. I would recommend reducing the weight of floating rates bonds in the portfolio gradually. The yield on fixed-rate bonds is getting attractive enough to hold them outright.

As for currencies, traders are already very long US Dollar, implying the upside to USD is limited. However, for the USD to weaken, global growth has to improve. The interest differential still supports the US Dollar. I do not expect any meaningful upturn in the Chinese economy until late Q2 of 2019. As Chinese economic activity weakens, European growth will sputter. Therefore, I expect the EUR/ USD to trade below 1.10 in the first half of 2019.

On that note, I wish you and your family all the best for this holiday season as well as a very Happy New Year. And if you celebrate Christmas – have a lovely Christmas!

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital

“Those who make peaceful revolution impossible will make violent revolution inevitable.”

Summary

The “political declaration” that Prime Minister Theresa May has agreed with the European Union (EU) is very vague and has very few details about what the future relationship between the EU and the UK will be. The declaration doesn’t commit the EU to anything. It’s not a legal agreement, unlike the 525-page “Withdrawal agreement”‘ which includes guarantees that are legally binding including the £39 billion “divorce bill” the UK will pay the EU, albeit over several years. Besides, the biggest bone of contention in the agreement – the Irish backstop – still remains. I do not see it passing the UK Parliament in its current form and even if it does, I strongly believe the Tory party will split and a new election will see Labour come to power. There is many a Conservative party voter who would not vote for the Conservative party again, such is the level of opposition to May’s “Withdrawal agreement.” Now, of course, all this could be averted if the deal were amended and the Irish backstop is either removed or has a fixed period of validity. I expect US economic growth to slow down next year and therefore believe that the US Federal Reserve (Fed) will pause hiking interest rates. I expect the Fed to increase rates only twice next year. The G-20 summit will be held at the end of this month in Argentina. With US President Donald Trump pushing publicly for a trade deal with China and China loosening its Joint Venture requirements ahead of the meeting, signs are that both sides want to make progress on this issue at the summit. We could see a rally in risk assets if a deal comes to pass or even if the 25% tariffs that are to come into effect in January are postponed. By the end of Q2, the US would have entered the 2020 Presidential election cycle and Trump will do all he can to get re-elected. For that, he needs a healthy economy, a high reading on the S&P 500 Index, low unemployment, rising wages and oh yes, no recession.

No Revolution Please, We’re British

Last Thursday was a day of feverish political frenzy in the UK. At one point it looked like the number of ministerial resignations could easily run into the double digits as displeasure within the Cabinet and the Conservative party grew with the Withdrawal Deal Prime Minister Theresa May had agreed with the European Union’s (EU) chief Brexit Negotiator Michel Barnier. Two cabinet resignations promptly followed including that of the Brexit Minister, Dominic Raab and rumours swirled that May could be pushed out in a vote of no confidence. As we waited for May to speak from the steps of Downing Street one of my staunchly Francophile colleagues remarked- “I really admire the English. They may be unhappy with Theresa May and her Brexit withdrawal deal but they don’t go out on the street and strike or carry out a revolution”. He was obviously drawing a comparison to strikes and protest, which are an essential part of life in France.

So why don’t the English revolt? Why in hundreds of years has there not been similar upheavals to the revolutions and civil wars in say, France or Russia?

The short answer is there have been revolutions in Britain – the Peasants’ Revolt of (1381), the Glorious Revolution (1688-89), the Jacobite rising (1715-1716) and others. The reason they are not remembered as well as the French Revolution or the Russian Revolution is that they were all unsuccessful. The rebels have only one success to show – the English Civil War of (1642- 1651) when King Charles I was defeated by Oliver Cromwell’s army and eventually executed. The English tried the new system – England as a Republic – for a decade, decided it didn’t work and in 1660 promptly reverted to the monarchy (albeit a constitutional monarchy with parliamentary controls) crowning Charles II (Son of Charles I) as King of England, Scotland and Ireland.

The long and considered answer is that for hundreds of years, Britain has been a more democratic nation, with a rich parliamentary history of reforms, when compared to other European nations and has granted more rights to its people sooner. The English had rights and property ownership going back over 800 years. The Magna Carta and the Doomsday Book are fine examples. The latter,a record of a huge survey of land and landholding commissioned in 1085, and the former, a charter of rights agreed to by King John of England at Runnymede, near Windsor, on 15 June 1215 that served as the foundation of the freedom of the individual against the arbitrary authority of the monarch/state. The Magna Carta became a major influence on the Constitution of the United States of America and the Bill of Rights, and the Constitutions of several other countries. Therefore, while the rest of Europe had to resort to political revolutions to win rights, the English didn’t have the same urge, or need, as the State reformed far more willingly (albeit under social pressure) and regularly.

As former US President John F. Kennedy said, “Those who make peaceful revolution impossible will make violent revolution inevitable.” Britain made “peaceful revolutions” and follow up reforms possible. The 1832 Reform Act gave a vote to the middle class. Its successor, the 1867 Reform Act gave a vote to every male adult householder living in towns. The Suffragettes movement in 1914 led to women getting voting rights. The social reforms in 1906-1914 brought in – Medical tests for pupils at schools and free treatment provided, compensation to workers for injuries at work, the introduction of a pension of five shillings for those over 70 that freed the pensioners from fear of the workhouse. In 1911, the government introduced the National Insurance Act that provided insurance for workers in a time of sickness and unemployment. And when the House of Lords resisted some of these reforms, an Act of Parliament in 1909 ended the veto of the House of Lords. Britain’s government was the model most Liberals throughout Europe sought to copy. The would-be rebels in Britain, therefore, have always had just enough “equity” to keep them from rebelling and burning down the establishment.

MVP
Source: Oxford University Press

The revolution that England is most remembered for is the Industrial Revolution and it spread to mainland Europe, including France. Further, a democratic vote in Britain is not one that is ignored or redone but implemented in toto and I have no doubt that the Brexit vote (unlike previous referendums on the membership of the EU in other parts of Europe) will be implemented in full.

On Thursday this week, May and Brussels signed off on a much-anticipated 26-page “political declaration” document that outlined the future relationship that the EU and the UK are committed to forging. A partnership that is “ambitious, broad, deep and flexible.” Just warm fuzzy words? We shall see. Agreement of the text paves the way for a special summit on Sunday at which May and the EU27 leaders will formally agree both the withdrawal agreement and the political declaration. May addressed the House of Commons in an emergency statement in which she reiterated that there would not be a second referendum as long as she was Prime Minister.

So what happens next?

The “political declaration” is very vague and has very few details about what the future relationship between the EU and the UK will be. The declaration doesn’t commit the EU to anything. It’s not a legal agreement, unlike the “Withdrawal deal” which includes guarantees that are legally binding including the £39 billion “divorce bill” the UK will pay the EU albeit over several years. Besides, the biggest bone of contention in the withdrawal deal – the Irish backstop – still remains. If, by the end of the transition period on 31 December 2020 a new trade deal between the EU and the UK is not agreed, then the Irish backstop would automatically kick in and Northern Ireland (or indeed the whole of the UK) would continue to remain part of the EU single market and customs union – i.e. UK will not be able to sign new trade deals with the rest of the world and will become a rule taker with no influence on future EU rules and regulations. Besides, once activated the backstop can only be revoked by the joint agreement of the UK and the EU. No party can individually call time on the backstop. The Brexiteers interpret this as a ploy by the EU to keep the UK in the single market and customs union for the long-term (if not forever) and deny the UK the Brexit it voted for.

I do not see the Withdrawal Bill in its current form with the Irish backstop passing through the UK Parliament and if it does, I strongly believe the Tory party will split and a new election will see Labour come to power. There is many a Conservative party voter who would not vote for the Conservative party again, such is the level of opposition to May’s Withdrawal Bill. Now, of course, all this could be averted if the deal were amended and the Irish backstop is either removed or has a fixed period of validity i.e. it pushes the EU and the UK to conclude a deal in an agreed time frame so that there is no need for a backstop to be activated. I do believe the deal will be amended. An addendum will likely appear that allays the backstop concerns when the bill is signed this weekend. Or it may not and when the bill is voted down in the UK Parliament in early December, the need for that addendum will become more urgent to avoid a No Deal Brexit. In any case, I still stick to my base case scenario that the willingness to avoid a No Deal scenario come March 29, 2019, is very high on both the UK and the EU 27 side. Therefore a solution will be worked out and the UK will leave the EU on March 29 next year and enter a transition period that will last at least until December 31, 2020.

The EU has major challenges ahead and its leaders are losing popular support. German Chancellor Angela Merkel is on her way out and French President Emmanuel Macron’s approval rating has dropped to 25% (the French hate almost all their Presidents. Francois Hollande had a 4% approval rating at one point in 2016). The Italian budget crisis and indeed Italian debt threaten the stability of the EU and the Euro and Greece is lining up for another bailout. Add to this the EU army, which I believe, will be busier averting/fighting internal battles than meeting external foes. The only countries still desperate enough to want to get in the EU are Ukraine and Scotland. In the case of Scotland, it hasn’t dawned on their leader Nicola Sturgeon that with over -8% budget deficit, Scotland is nearly three times over the budget deficit target needed to join the EU. If Scotland were to leave the UK, the savings to the UK in transfer payments to Scotland will be far higher than anything promised on the side of the red bus by the Brexiteers. If Nicola Sturgeon wants independence she should let the English vote in the next Scottish referendum.

Markets & Economy

For the fifth time this year, the S&P 500 Index (SPX) is down by more than -5% from peak-to-trough with two drops of greater than -10% recorded in January and October. Contrast this to last year when we didn’t have a single drop of more than -3% and the year finished with a gain of +20% for the index. Much of the move this year is attributed to – a maturing economic cycle, tariff uncertainty primary (but not limited) to a US-China trade war and the US Federal Reserve (Fed) in a tightening mode. Despite the market volatility, all through the year, the Fed is still set to hike 4 times in 2018 with the last hike likely to come at its December meeting. If that were the only tightening, we’d probably be fine. However, as markets are interlinked, the US Dollar has also strengthened and further tightened the financial conditions for Emerging Markets causing them to slow down. The big difference in the performance of equity markets in local currency versus in US Dollar terms highlights this currency effect (see table below). To add to this, the Fed balance sheet drain is also proceeding at a gradual pace i.e. another tightening move to add to the two above – rising rates and a strong US Dollar.

MVP

I do expect the US growth to slow down next year and therefore believe that the Fed will pause hiking interest rates. I expect the Fed to increase rates only twice next year. Having said that, I do not see a US recession on the horizon. The US economic cycle has further to run and US consumers, in particular, remain strong. The sell-off, therefore, represents a buying opportunity for global stocks. Brexit, political risks in Italy, trade tensions and a potential slowdown in China could overhang longer but don’t forget ultimately a resolution of the issues is in the mutual interest of the parties involved. No wonder European Central Bank (ECB) President Mario Draghi says there will be a deal between Italy and the EU to resolve the budget crisis and Trump is publicly signalling a détente with China.

The G-20 summit will be held at the end of this month in Argentina. In 2016, we saw a similar tightening of financial conditions with the concerns that the Fed was being too tight too soon. As a result, USD was strengthening, CNY was weakening and Oil was getting battered. The G20 summit then in Hangzhou led to a “Hangzhou pact” as policymakers decided that tightening financial conditions was not an optimal policy. Are we seeing a similar setup today? With Trump pushing publicly for a trade deal with China, the Fed starting to show some wiggle room, and China loosening its JV requirements ahead of the G-20 meeting, we could see a rally in risk assets if a deal comes to pass or even if the 25% tariffs that are to come into effect in January are postponed. Peter Navarro, the controversial White House trade policy adviser and a famous China hawk, has been excluded from the Xi Jinping-Donald Trump dinner at the G-20 in Buenos Aires on December 1. Exclusion of a famous China hawk and a key figure behind the US-China trade war indicates that both sides want to make progress on the dispute at the summit. I do see a comprehensive US-China trade deal being signed by the end of Q1/early Q2. One has to just remember – America has elections, China does not. By the end of Q2, the US would have entered the 2020 Presidential election cycle and Trump will do all he can to get re-elected. For that, he needs a healthy economy, a high reading on SPX, low unemployment, rising wages and oh yes, no recession.

In investing, a keen eye for history is always very helpful. So if you are frustrated by the volatility this year and want to sell everything and go into cash as you believe a recession is down the corner in the US, then the next three paragraphs are particularly useful for you. I suggest you read them carefully and take note of the statistics.

It’s correct that this US recovery, which started in Q2 2009, has gone on for a long time but that is no reason for it to end and a recession to set in. Australia hasn’t had a recession in 27 years and as we all know Australia is very much on planet earth just as the rest of the world and trades with earthlings and not Martians.

Here are few key stats that I came across while reading a RiskHedge report on the MarketWatch website.

  • Since 1946, there have been 18 midterm elections and US stocks were higher 12 months after every single one. Yes, every single one. That’s 18 for 18.
  • Since 1946, stocks have risen an average of +17% in the year after a midterm election.
  • If you measure from the yearly midterm lows, the results are even better. From their lows, stocks jumped an average of +32% over the next 12 months following a midterm election.
  • We’re also entering the third year of a presidential term, which is historically the strongest year for stocks (see chart below). You will note that the performance of stocks in the third year of a presidential term beats all other years by a long shot. Therefore do not throw in the towel and go into cash just yet.

MVP

In the chart above you’ll also notice the second year of the presidential cycle is typically the worst for stocks. That’s the year we’re in right now — the year when midterms occur. The SPX was as high as +9% in October and is now flat. We still have 5 weeks until the end of the year. A run to 2800 (very possible) could still make it a +4% year for the SPX.

With Germany experiencing negative GDP growth in Q3 this year, things are not looking well for the European growth story. A US-China deal, of course, would help. It seems Greece is in need of another bailout, something I predicted in the August newsletter. I wrote then – “Only in the EU could a bailout be described as ended by completely ignoring the over €330 billion that has to be repaid by 10 million people who don’t like paying taxes. Besides the taxes and regulatory burdens put on Greece as part of the bailout program have made growth unstainable and economic prospects still remain grim. The charade of interest payment deferrals and extending the maturity of the debt can only go so far. So give it a few months and Greece will be back in the news seeking a fresh bailout. Greece is like Groundhog Day but without the happy ending.” In retrospect, those words are quite prescient now. I am not bullish on Eurozone growth and don’t see how the ECB will be able to end its quantitative easing (QE) policy this year in face of a growth slowdown and negative growth in EU’s largest economy. I still prefer to be overweight the US economy and the US Dollar and find Emerging Market (EM) equities very attractive. Low oil prices are a boost to many including India, Korea, China and indeed US consumers.

MVP
Source: Bloomberg

Chinese equities (ASHR) are making an attempt to bottom. The recent lows have held so far and are right near the bear market low that was made back in early 2016. The ASHR ETF has recently made two “higher lows” (chart above), a classic bullish turning point. If the Fed policy turns more dovish and/or Trump starts to soften on trade, ASHR should see very good gains.

I believe the concerns about Apple (APPL) are overdone. Apple is not at the limit of its price premium for the iPhone. It’s true when pricing power is lost; consumer technology companies tend to either lose margins or market share or both. Apple phones are still a premium product and vast sections of consumers in the EM are yet to join the mobile phone world and get connected. I have added to Apple (APPL), Google (GOOG), Amazon (AMZN), Alibaba (BABA), Micron Technology (MU) and other tech positions to our portfolios.

I continue to be long US equities, with sector preferences for Technology (XLK), Financials (XLF), Healthcare (XLV) and Industrials (XLI). I also recommend an increased allocation to Emerging Markets Equities.

In terms of stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IBM US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US), Societe Generale (GLE FP), Kering (KER FP), Mastercard (MA US).

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital

“The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge. ”

Summary

Big electoral losses in the State legislature elections in the second and the fifth most populous states in Germany – Bavaria and Hessen – have dealt further blows to German Chancellor Angela Merkel and her ruling coalition. The move to the right (and in some cases far right) in recent elections in the US, UK, Germany, Austria, Netherlands, Italy, Sweden, Poland, Hungary and so on, indicates that, in the Western economies at least, the leftist parties have become rigid ideologues that no longer truly represent their people. Voters are therefore abandoning them and are willing to try new and untested political parties and personalities. This polarization is set to continue and, in Europe, the full effect of it will be felt in the upcoming European elections in May when the “populists” from across Europe take their seats in the European Parliament in Brussels in increased numbers. I believe Merkel is on borrowed time. Giving up the Chair of her party will increase the pressure on her to resign as Chancellor before her term ends in 2021. The Presidential election in Brazil, Latin America’s biggest economy and the world’s fifth most-populous country, brought another populist to power. Jair Bolsonaro is quite a controversial figure with polarizing views on many a topic. But the fact that Brazil still voted him in says how tired Brazilians are of the last 13 years of the Workers’ Party (PT) rule, during which time corruption, debt and the deficit soared and Brazil fell into its worst recession in more than a century. The last three Presidents of the country have all been implicated in scandals and bribery. There was a feeling that if the PT returned to power, it would pick up where it left off and eventually turn Brazil into another Venezuela. Bolsonaro has pledged to clean up politics, crack down on crime, end Brazil’s flirtation with socialism, privatize and deregulate, rein in deficits, and open up the economy. If he delivers on even half his manifesto, Brazil would be the winner.

Merkel: a lame duck Chancellor?

The unemployment rate in Germany is at a 40-year low. The trade surplus is at a record high and, last year, Germany, experienced its best GDP growth in a decade. Yet Germans seem unhappy with Chancellor Angela Merkel who has been Chancellor for the last 13 years. Ever since Merkel opened Germany’s borders to nearly two million refugees three summers ago, things have not been the same in Germany, either socially and politically. Germany’s political mainstream, dominated by the Christian Democratic Union (CDU) and the Social Democrats (SPD) has been on the retreat. Big electoral losses in the state legislature elections in the second and the fifth most populous states of Germany – Bavaria and Hessen – have dealt further blows to Merkel and her ruling coalition.

Earlier this month, the affluent Bavaria with a population of over 12.5 million and home to such companies as BMW, Siemens and Adidas, stunned the incumbent Christian Social Union (CSU) – sister party to Merkel’s CDU – when it lost its absolute majority, its worst result since 1950 (chart below). To pile on the misery, over the weekend, the State elections in Hessen – home to Germany’s financial industry- dealt another blow to the “grand coalition” parties – the CDU and the SPD with the CDU polling 27.9% and the SPD plunging to 19.8% (chart below). In the last election, in 2013, the CDU and the SPD scored 38.3% and 30.7% respectively. The far-right Alternative for Germany (AfD) which didn’t exist 10 years ago and became the largest opposition party in the German parliament in the general election last year, polled 13.1% to enter the Hessen state legislature for the first time. The AfD is now represented in all 16 of Germany’s regional assemblies and has built a solid base throughout Germany as it continues to gain traction with German voters.

MVP

More worryingly, both the CDU and the SPD have seen their national ratings plummet further since the federal election in September 2017. Last week, a nationwide Emnid poll found that the support for the CDU/CSU has shrunk to a record low of 24% (down from 32.9% in September 2017), while the SPD dropped from 20.5% to a lowly pitiful 15%. The AfD is now polling ahead of the SPD at 16%. The grand coalition of – the CDU/CSU and the SPD together now account for 39% of national support, a big fall from the over 67% support they enjoyed just over a year ago. German voters continue to show their disappointment with the open border policy of Merkel. A yearning for change is evident among CDU and SPD supporters, who feel betrayed by their leaders.

The move to the right (and in some cases far right) in the recent elections in the US, UK, Germany, Austria, Netherlands, Italy, Sweden, Poland, Hungary and so on, indicates that, in the Western economies at least, the leftist parties have become rigid ideologues that no longer truly represent their people. Voters are therefore abandoning them and are willing to try new and untested political parties and personalities. This polarization is set to continue and in Europe, the full effect of it will be felt in the upcoming European elections in May when the “populists” from across Europe take their seats in the European Parliament in Brussels in increased numbers. Until such time as the main political parties stop undermining their own people and betraying their values, things will only get worse and, in some countries, much worse than today.

Merkel is powerless to stop the erosion of support. This week she announced that she would not seek re-election as Chair of her party a post she has held for the past 18 years. But will that be enough? Can she cling on as Chancellor for the rest of her term ending in 2021? I believe Merkel is on borrowed time. Giving up the CDU chair will increase the pressure on her to resign as Chancellor before her term ends. So, what happens when she goes?

In the medium term, it will only increase worries as there is no clear successor to Merkel and therefore we won’t know what the new Germany will look like. A weak or uncertain Germany is bad for Europe. Serious decisions remain to be made on the future of the Eurozone: Migration, defence, the European Monetary Fund, the Italian budget deficit and other issues – let alone negotiating Britain’s exit from the European Union (EU). If Germany gets wobbly, the EU could drift untethered and directionless and stumble from one crisis to another.

Brazil turns right

Latin America’s biggest economy and the world’s fifth most-populous country, Brazil, has a new President – Jair Bolsonaro, a former army captain. Bolsonaro beat his left-wing rival Fernando Haddad by 55%-45%. For the first time since 1989, neither the Workers’ Party (PT) nor Brazil’s other political heavyweight, the centrist Brazilian Social Democracy Party (PSDB), has won the Presidency.

Bolsonaro is quite a controversial figure with polarizing views on many a topic. Perhaps a lot of it is loose electoral talk, but the fact that Brazil still voted him in says how tired Brazilians are of the last 13 years of PT rule, during which corruption, debt and the deficit soared and Brazil fell into its worst recession in more than a century. There was a feeling that if the PT returned to power, it would pick up where it left off and eventually turn Brazil into another Venezuela.

Brazil is still struggling to return to strong growth after GDP fell -3.9% in 2015 and -3.5% in 2016.

MVP

The recovery has been anemic and Brazil is struggling with unemployment of +12%, a high debt/GDP ratio of 80% and a worrying budget deficit of +7% of GDP.

The profligacy and corruption of 13 years of left wing government is largely responsible for the mess that Brazil is in. The last three Presidents have all been implicated in scandals and bribery. Luiz Inacio Lula da Silva, president from 2003–2011, was sentenced in July 2017 to nine and a half years in prison for corruption and money laundering. Dilma Roussef who succeeded Lula in 2011 was impeached and then removed from office in 2016. Michel Temer, Rousseff’s one-time running mate and Vice President took office in August 2016 after Rousseff was impeached and has since been charged with taking bribes. Brazilian voters have been so angry at the last 13 years that some took to referring to Bolsonaro as the best available “pesticide” or “chemotherapy” Brazil now has to protect itself from the PT’s return.

Mansueto Almeida, an economist at Brazil’s Finance Ministry explains that approximately two-thirds of the country’s budget goes towards paying old-age pensions, public health care and the payroll of Brazil’s bloated public sector. If this continues then by 2020 those liabilities will have grown so much that there will be nothing left over for discretionary spending items such as roads, new hospitals or police equipment. A debt crisis is looming. Brazil is one policy mistake away from ushering in a return of the IMF.

This election, therefore, was a choice between more of the same or a course correction and revival. Brazilians very wisely chose the latter. Reform will not be a cakewalk but more of the failed policies of the PT sure would be a road to perdition. While the media likes to label Bolsonaro as far right, for many in Brazil, Bolsonaro whose middle name means “Messiah”, is a saviour.

Bolsonaro has pledged to clean up politics, crack down on crime, and set a new direction for his country. “We cannot continue flirting with socialism, communism, populism, and leftist extremism … We are going to change the destiny of Brazil,” Bolsonaro said in an acceptance address, promising to root out graft and stem the tide of violent crime. Bolsonaro’s chief economic adviser is Paolo Guedes, a Chicago University-trained economist and investment banker advocating radical privatization and small government. However, the new President’s success will depend on his ability to unify a deeply divided nation and to find a majority in Congress in order to implement his reform agenda. While Bolsonaro’s Social Liberal Party is now the second-largest party in the lower house, it still has only 52 out of 513 seats. The Lower House remains split between ten parties that account for around 60% of the seats. There is a similar split in the Senate. Hence, forming a coalition will likely be tough. Bolsonaro backs an independent central bank, privatization and deregulation, fiscal austerity, opening the economy, and a move away from failed industrial policy. If he delivers even half that, Brazil will be the winner. Watch out for the Brazil equity index BOVESPA and the Brazil ETF (EWZ US).

Markets & Economy

Last week the equity market sell-off that so far had only hit Emerging Markets and Europe reached US shores and as it has wiped out all year-to-date gains of the S&P 500 (SPX) index, while leaving other indices in a sea of red (see table below)

MVP

So where to from here? What is the level that the SPX could fall to before it becomes an attractive buy?

If the sell-off in the US equities continues, it will be a case of throwing the baby out with the bathwater. US GDP expanded at the rate of +3.5% per annum in the third quarter. Consumer spending rose +4%, a stronger rate than the prior quarter and government spending picked up as well. The US economy is set to grow above a +3% rate during 2018. That hasn’t happened since 2005. At the same time, inflation cooled in the third quarter i.e. it should ease the pressure on the US Federal Reserve (Fed) to continue raising interest rates.

While it’s easy to turn bearish if the market is at an all-time high, there’s one thing I find contradictory about the bearish commentators out there. The same folks who say growth has peaked, seem to suggest that the Fed will keep increasing rates and therefore the sell-off will continue. Why on the earth would the Fed keep increasing rates if growth has peaked?

I don’t disagree that US growth may be easing with the second quarter growth of +4.2% being the peak quarterly growth of this business cycle – when the biggest impact of the Trump tax cuts was felt. If that is the case, then the Fed will again find it difficult to stay on the rate hike path i.e. equities should get support. A dovish hike in December, where the Fed raises rates but lowers the forward rate projections (dot plot) would be supportive for US equities as well as Emerging Market equities and bonds hit by a strong USD. If growth and inflation both fall back to +2% by mid next year then I would expect this rate cycle to top out at +3% and not +3.5%, as currently anticipated. A long pause from March – September 2019 would be enough to get equities higher again and steepen the yield curve for banks’ earnings to do well.

There’s one more thing to watch out for. Markets may be underestimating the amount of government spending that will come from already approved budget appropriations and we saw a sign of this in higher government spending figures in Q3 GDP released last week and mentioned above. A capital-spending program by the government would encourage companies to invest in capital and production in anticipation of nominal growth rather than financial engineering.

Based on the current earnings number of $175-$179 Earnings per Share (EPS) for 2019 and $165 in a bearish case, there’s strong support for the SPX at the 2650 level, i.e. at a P/E of 16. I expect the SPX to bounce back to the 2850 level and a dovish Fed in December could set it nicely for a test of 3000 in early 2019.

And let’s not forget that President Donald Trump is talking of another tax cut. The poll numbers for the US midterm elections have started moving back in favour of the Republicans and they look to retain the Senate comfortably. Generic ballot numbers still indicate a 50/50 House of representatives, as we head into the final stretch with the Democrats losing steam as more voters return to the red corner.

The next area to focus on would be the strength of the US dollar, with way too many Fed rate hikes priced in for 2019, if growth is indeed slowing. I would, therefore, increase exposure to Emerging Market bonds and equities in anticipation of US Dollar weakness. Also I would recommend a move into more value sectors – Energy, Industrials, and Financials.

MVP

While I am not concerned about the US economy in the short term, I am concerned about it in the medium to long-term.. Trump’s tax cuts and an increase in government spending means that, in 2020, the US will be borrowing more than $1 Trillion plus while the US economy will only grow by $400 billion (taking GDP growth at +2% for 2020). In other words, the US will be going deeper into debt at the rate of $600 billion a year. While stimulus-driven growth that borrows from the future is fun in the short-term, it’s not so good in the long run. So yes, 2019 and definitely 2020 will be big worries for the US economy, and the world, if growth slows down.

Meanwhile, in Europe, stocks fell as the tussle between Italy and the EU intensified. The EU took the unprecedented step of rejecting Italy’s draft budget as incompatible with the bloc’s rules on fiscal discipline. Yields on 10-year Italian government bonds have risen to +3.6% from less than +2% in May. European Central Bank (ECB) President Mario Draghi has refused to intermediate, however, he reiterated that Italy and the EU would come to an agreement. “I’m confident an agreement will be found,” Draghi said of the standoff.

Of course, nobody expected the EU to give in immediately, but they will give in eventually. The higher deficit may be the only way to avoid an economic crisis in Italy. Italy has a growth problem and needs the deficit spending to support growth. Arguing over whether the deficit should be -2% or -2.4% of the GDP is like arguing about what music to play on the Titanic after it hit the iceberg. Even if Italy accepts the -2% target, the deficit may slip to over -2.5% or even -3% if growth slows down further.

French and German banks are again exposed to Italy in a big way (chart below) as they were to Greek banks. French banks look particularly exposed. As of June, French institutions had some $316 billion (over 14% of France GDP) in Italian investments, according to the Bank of International Settlements (BIS). That’s much more than they ever had in Greece. German banks’ claims on Italy, at $91 billion (3.2% of Germany’s GDP), are smaller but still significant.

MVP

I continue to be long US equities, with sector preferences for Technology (XLK), Financials (XLF), Energy (XLE) and Industrials (XLI). I also recommend increasing exposure to European equities now that they have fallen to oversold levels – Financials, Industrials, Healthcare, Autos and Luxury stocks are my favourite sectors. An increased allocation to Emerging Markets equities is also recommended

And finally what happens after we’ve had a bad October? How soon does the SPX recover? Here are some stats from S&P 500’s history dating back to 1928, for October sell-offs of more than -4%:

MVP

In terms of stocks I like : VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IBM US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US), Valeo (FR FP), Ford (F US), Societe Generale (GLE FP), Kering (KER FP), Mastercard (MA US).

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital

“If you are the smartest person in the room, then you are in the wrong room.”

Summary

I can understand why the Brexiteers are opposed to the UK’s Chequers proposal, but I do not understand the European Union’s opposition to it. The Chequers deal would hamstring the UK, make it an EU rule-taker and keep the UK in the “single market.” There would be no realistic prospect of the UK reaching trade agreements with other nations, if the UK were not seen as having control of domestic rules or laws or being a credible negotiating partner. In my opinion, the EU, in pushing the envelope and rejecting the deal, has miscalculated. The Chequers deal is better for the EU than a “no-deal” or any other deal frankly. UK Prime Minister Teresa May will now do well to turn this rejection of her proposal into an opportunity and make a clean Brexit because that’s what Brexit means – the parting of ways and not a half-way house between the UK and the EU. As for the fantasy of a second referendum, unless the EU is willing to move to a multispeed EU with consent as the basis of an ever-closer union (i.e. Europe a la carte), there is no point in offering another referendum. It will result in the same outcome. Despite the antics and acrimony, I do see the UK and the EU concluding a deal, and it will likely be before year end. Now it is also possible that there might not be a big bargain deal to be had, in which case you will see a series of sector-by-sector deals to minimise disruption and some sectors may trade on Word Trade Organisation guidelines in the immediate aftermath of Brexit before concluding a final deal. The modern world has complex supply chains, and the UK and the EU particularly so, given their history and trade over the last 50 years. Getting a deal and minimising disruption is a priority both for the UK and the EU.

Chequers chucked, so what next?

That there was no deal on the UK’s Chequers proposal at the European Union (EU) Summit in Salzburg last week, shouldn’t have come as a surprise to anyone. The half in/half out deal that this proposal called for, was opposed both within the UK and in Brussels – with only Prime Minister Theresa May pushing for it. The Chequers proposal would provide the UK access to the EU “single market” on goods after Brexit, while services would be governed under different rules. In return, the UK would accept the EU’s “common rulebook” – standards governing manufactured and agricultural products.

Leading Brexiteer Boris Johnson described this proposal as a “suicide vest” for the British constitution. The European Research Group (ERG), a grouping of Tory Eurosceptic Members of Parliament (MPs), who number close to 80, had warned that they would vote against the Chequers plan in Parliament. Brexiteers were opposed to the Chequers proposal as it would hamstring the UK, make it an EU rule-taker and keep the UK in the “single market.” There would be no realistic prospect of the UK reaching trade agreements with other nations if the UK were not seen as having control of domestic rules and laws or being a credible negotiating partner. Michel Barnier, the Chief EU negotiator on Brexit was opposed to the Chequers proposal too. Barnier remarked “les propositions sonts mortes (the proposals are dead).”

I can understand why the Brexiteers are opposed to the Chequers proposal, but I do not understand the EU’s opposition to it. In my opinion, the EU, in pushing the envelope, has miscalculated. The Chequers deal is better for the EU than a ”no-deal” or any other deal frankly. The Chequers deal would have essentially kept the UK in the single market for goods (where the EU has a trade surplus of +£100 billion with the UK) and would have kept the UK out of the single market for services (where the EU has a deficit of -£28 billion). The EU would thus continue to sell goods and keep its huge surplus in goods intact. But the EU doesn’t do economics, it does ideology. Ideologically, Brussels saw the Chequers proposal as breaking up the “single market.” In their opinion, enjoying the benefits of the single market (albeit only in goods) without free movement of people would make Brexit look easy. Brussels worried that more copycat departures could follow and the EU would eventually collapse. I disagree with this thinking entirely.

“In my opinion, the EU, in pushing the envelope have miscalculated. The Chequers deal is better for the EU than a no-deal or any other deal.”

‎Just because the UK is leaving the EU and can make a success of it, it doesn’t mean that others will follow suit. If leaving and making a success of it were so easy then Greece and Italy would have left the EU long ago, reclaimed their currencies back and embarked on efforts to reduce crippling debt and rebuilt their economies. It has taken the UK over a decade to organise an “in-out” referendum since it was first mentioned in 2007. It will take a good few years for the UK to chart a path independent of the EU despite the UK having an independent monetary policy and several opt-outs in its current EU membership. Leaving is one thing and making a success of it is quite another. Out of the twenty-eight EU nations, eighteen are net recipients of EU funds, so they are not going to leave the “free money” anytime soon. Of the ten who are the net contributors Germany, the UK, France and Italy contribute the most, and are candidates to leave in a theoretical discussion. However, Germany is the biggest beneficiary of EU project so it won’t leave (until the cost of keeping the EU together outweighs its benefits). France punches above its weight and the EU helps it do it, so they wouldn’t leave either. Italy with over €2.3 trillion of debt and moribund GDP growth has much to ponder before they can consider leaving the EU and the Euro.

The divide between the EU and the UK is one of history and beliefs. It’s about Catholicism vs. Protestantism as political scientists Brent Nelsen and James Guth describe in their book, “Religion and the Struggle for European Union.” Broadly speaking they suggest, Catholics favour the EU more than Protestants. These attitudes were forged in the Reformation that took place in 16th Century Europe. It led to the development of two different approaches to governance in Europe. Catholics see Europe as a single cultural whole that ought to be governed in some coordinated way. Protestants, on the other hand, see the nation state as a bulwark against Catholic hegemony and a guarantor of individual liberty. On the Continent, people are used to the State/supranational bodies running the country. Brussels taking over ”governing” in the 20th Century is no different than Imperial France or the Austro-Hungarian Empire that ran Europe in the 18th and the 19th Centuries. It’s a continuation of history. If you suggest this to Europeans, they may not see it this way. They will tell you that Europe has come far, but the reality is they haven’t come that far and history is not on their side. Their acceptance of the EU is far deeper and not based on reason but a habit. A habit formed over many centuries.

So where do we go from here?

PM May will now do well to turn this rejection of her Chequers proposal into an opportunity and make a clean Brexit because that’s what Brexit means – the parting of ways and not a half-way house between the UK and the EU. It’s time to move on to a “Canada +” deal. At its most basic, a Canada-style deal, is the UK striking a free trade deal with the EU after Brexit along the lines of the agreement the EU recently signed with Canada. This would remove most, if not all, customs tariffs on goods sold between the EU and the UK and potentially allow some market access for services.

So, will the EU accept it readily? Not really. In the EU’s infinite wisdom, this solution would not solve the problem of the Irish border. Brussels fears that Ireland could become a backdoor into the EU market for goods from around the world that may not comply with EU’s standards and tariffs. So, for a Canada-style deal to happen, the UK would have to give assurances on regulations and standards the EU holds dear. If the EU is not assured, it would effectively put a customs and regulatory border in the Irish Sea, something that is unacceptable to PM May. The backers of a Canada-style deal reject the EU’s reservations about it and have long maintained that with the use of technology it would be possible to ensure that goods crossing between Northern Ireland and the Republic fulfil customs requirements without the need for physical infrastructure at the border. The EU physically checks only around 3% of imports, the rest is done electronically and with mutual recognition of standards. So, it is not a big problem to do the same with the Northern Ireland- Republic of Ireland border.

“An intransigent EU will be playing into the hands of those in the Trump administration who want to break the EU and reduce US funding for NATO. The consequences of a No Deal will be far-reaching”

As I have said in the past, despite the antics and acrimony, I do see the UK and the EU concluding a deal most likely before year end. Now it is also possible that there might not be a big bargain deal to be had, in which case you will see a series of sector-by-sector deals to minimise disruption and some sectors may trade on WTO guidelines in the immediate aftermath of Brexit before concluding a final deal. The modern world has complex supply chains, and the UK and the EU particularly so, given their close history and trade over the last 50 years. Getting a deal and minimising disruption is a priority both for the UK and the EU. It remains an issue of mutual recognition of standards. Besides Brexit is not merely a matter of economics. The UK may be leaving the EU, but it is not leaving the US-led Western alliance. The UK’s role is key to sustaining US support for Europe and the guardian of peace in Europe – the North Atlantic Treaty Organisation (NATO) that US President Donald Trump has threatened to withdraw from. An intransigent EU will be playing into the hands of those in the Trump administration who want to break the EU and reduce US funding for NATO. The consequences of a No Deal will be far-reaching. This is well understood in Brussels.

As for the fantasy of a second referendum, unless the EU is willing to move to a multispeed EU with consent as the basis of an ever-closer union (i.e. Europe a la carte), there is no point in offering another referendum. It will result in the same outcome. An EU which hasn’t bothered to get its treaty ratified by member states (because it can’t be sure of the outcome) and ignored the result of previous referendums in member states, is galaxies away from a Europe a la carte. Those seeking a second referendum are wasting their and everyone’s valuable time. They are well advised to offer their time, money and services to charitable work. ‎

Markets & Economy

As expected the US Federal Reserve (Fed) raised interest rates by +0.25% Wednesday, as it continues to gradually roll back its policies of easy-money. This lifts the Federal-Funds Rate to between +2% and +2.25%. The increase, is the third this year and the eighth since the Fed began to raise rates in late 2015. For the first time since 2008 the benchmark rate is above 2% and also above inflation, measured by the Fed’s preferred gauge, Personal Consumption Expenditures (PCE) which excludes the volatile energy and food categories. The so-called core PCE index rose +2% in July. Fed Chairman Jerome Powell remarked, “This gradual return to normal is helping to sustain this strong economy for the longer-run benefit of all Americans.” Trump, in a press conference later said he was “not happy” about the Fed raising rates. He however added, “They are raising them because we are doing so well” and that higher rates weren’t all bad because they could help Americans who rely on interest savings for income.

Between this rate increase and the Trump tax increase, I mean the Trump tariffs, the US economy risks slowing down. How soon that happens will depend on the level of tariffs implemented and how quickly the Fed continues to raise rates. The Fed hinted it will raise rates one more time this year and by one percentage point through next year. If Trump raises tariffs to 25% and they stay there, and the Fed Funds Rate goes up to 3% or more, then recession fears will increase. For now, I have no such fears.

While the China-US trade war has dominated the narrative over the last quarter, rising oil prices are now getting everyone talking. Impending sanctions on Iran have lifted crude prices. Trump has called for the Organization of the Petroleum Exporting Countries (OPEC) to increase the oil supply and stop “ripping off the rest of the world” by pushing oil prices higher. However, at its meeting in Algiers on Sunday, OPEC and Russia reiterated that they want to adhere to current production quotas first implemented at the start of 2017. If the glut of oversupply goes, demand continues to increase and US oil inventories fall – then US sanctions on Iran and a Trump defiant OPEC spell higher oil prices. Brent could easily get to $90 and over in the short term.

Source: Bloomberg

Regular readers of this newsletter will know that I have been bullish on US equities and overweight US equities for a long time now and even during all of this year, despite the market talk of recession and an impending market correction. The S&P 500 index (SPX) has not disappointed and continues to pass the “back to school” test as we enter autumn after a volatile summer. The SPX broke out to a new high (chart above) at the end of August and pulled back in early September. Crucially the pullback found support right at its prior highs from January. After holding that level, the SPX has continued to trade higher. If you are a chartist, it doesn’t get much more textbook than this. With the US economy growing at over +3.5%, no signs of a recession on the horizon and a measured escalation of the US-China trade war, the SPX has legs to continue reaching new highs. Besides, many investors and commentators are still sceptical about the SPX rally and that’s a good thing. You should worry when everyone is bullish.

While the SPX index has recovered nicely from a pullback early this month and is up +9% Year-To-Date (YTD), Europe’s flagship Euro Stoxx 50 (SX5E) Index has slipped down further, -2.3% YTD, and so has the MSCI Emerging Market Index, -10% YTD (table below). The SX5E could have been worse off had we not seen a rally in European stock (particularly financials) on the back of reducing confrontation between Italy and the EU over the Italian budget. The Italian government officials from both parties – 5 Star Movement and the League – have pledged to respect EU rules limiting deficits, after a squabble to break EU rules on fiscal discipline led to heavy selloffs of Italian bonds over the summer.

The prospect of a quick resolution to the US-China trade war has dimmed. Trade tensions between the US and China will be a drawn-out affair as this is more than a trade spat. It’s about global influence and leadership. Jack Ma, Alibaba’s Executive Chairman rightly remarked – “It’s going to last long, it’s going to be a mess. Maybe 20 years.” Early this week China cancelled trade talks set for this month and the US imposed 10% tariffs on $200 billion of Chinese exports to the US. China responded with tariffs on $60 billion of US exports to China. This is likely to beget US tariffs on the remaining $267 billion of Chinese exports to the US i.e. just about all imports from China would face a tariff going forward.

The war of words will continue and as Winston Churchill and Harold Macmillan used to say “Better jaw-jaw than war-war.” I think the world and markets can endure a war of words, however long this takes. The US is the declining power and China is the rising power, but there needn’t be a war. The sensible thing for the US to do would be to agree on a deal with China and open China’s market to US products. China is shifting its economy from being the world’s largest exporter to the world’s largest consumer. Speaking at the World Economic Forum (WEF) early this year Chinese President Xi Jinping remarked that over the coming five years, China would import $8 trillion of goods. US companies want in on this. Trump may have his own ideas but he is not an ideologue. You can see that from the exemptions granted to a range of products (particularly Apple’s products) in the latest round of tariffs imposed by the US. US businesses and indeed European businesses are not ready to forfeit this opportunity of China trade – an emerging Chinese middle class of 300 million people with average income growing at almost double digits. The US will have to learn to live with reduced influence as China rises until such time as China has its own political troubles. The US doesn’t have to worry about any other power eclipsing it. A declining and bureaucratic Europe will never be much of a challenge to the US and Russia may be a military power but it will never be an economic power given the paranoia and mistrust that grip the nation and its leadership.

Having said that, the EU’s announcement this Tuesday that it would establish a special payments channel to maintain economic ties with Iran is significant and it may be a first step to challenging the supremacy of the US Dollar. Should America be worried? Not so fast. Can American counter the threat? Absolutely. You can do business with Iran or you can do business with the US, but not both. The risk of losing access to the $20 trillion US economy and being cut off from the Western financial system can sober any business and the next time the ECB comes to the US Federal Reserve window to arrange Dollar swap lines, you can be sure what the response will be. European banks will be foolish to provide payment options to companies seeking to do business with Iran. It will be like picking up pennies in front of the steamroller. The US Dollar will meet its challenge but this is not the moment.
After having a bad first half of the year, Q3 has been extremely good for the Healthcare, Industrials and Financial sector stocks. As the table below indicates, almost all of the year-to-date performance for Healthcare stocks has come in Q3. This good performance is set to continue. Healthcare stocks are seen as safety stocks and as the rally gets old, defensive sectors – Healthcare, Consumer Staples, and Utilities will see increased inflows. Again, as I have said above, I do not see a US recession on the horizon and an inflation surprise to the upside also looks distant.

I continue to be overweight US stocks with sector preferences for Technology (XLK), Financials (XLF), Healthcare (XLV) and Industrials (XLI). I remain underweight Europe and underweight Emerging Markets.

In terms of stocks I like : VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IMB US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Netflix (NFLX US), Twitter (TWTR US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US)

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital

“’If you tell the truth, you don’t have to remember anything.”

Summary

China and the US are talking again and that’s a good thing. With 2Q’18 US GDP growth of +4.2% and historically low unemployment levels, US President Donald Trump must know he has a window to renegotiate a trade deal with China from a position of strength. However, he mustn’t forget that the window will not remain open forever. The strong GDP growth in 2Q is attributable to a pick-up in trade activity in advance of the implementation of tariffs and increased consumption on the heels of the recent tax cut. Tax cuts are one-time adrenaline shots. A shot that Trump cannot administer or afford at will. Patriotism has its price and particularly in free, capitalist and profit-seeking economies such as the US and the UK where governments cannot coerce capital to act against their interest. Capitalists have no nationality or national interest and they tend to gravitate towards opportunities that offer the best risk-adjusted return. Unless of course you are a capitalist in Russia or China and then you do what the government tells you to. The US will pay its farmers $4.7 billion to offset losses from the tariffs imposed by China on agricultural imports from the US. A second wave of direct payments to farmers is likely to follow if tariffs persist. The farmers “cannot pay their bills with patriotism” and patriotism has its price. As Trump ratchets up the number of Chinese exports that he is willing to levy a tariff on, Americans will be faced with the question – at what price patriotism?

At what price patriotism?

This week we learnt that the US will pay its farmers $4.7 billion to offset losses from the tariffs imposed by China on agricultural imports from the US. Furthermore, the US Department of Agriculture (USDA) could decide by December to make a second wave of direct payments to farmers if damages from trade tariffs persist. The farmers “cannot pay their bills with patriotism” and patriotism has its price.

Last year, Michael Anson, who works in the Bank of England’s (BoE) archive along with Norma Cohen, Alastair Owens and Daniel Todman from Queen Mary University of London, made a startling discovery – the spectacular failure of UK’s first bond issue of the Great War in 1914 and the extraordinary role of the Bank of England (BoE) in the cover-up that followed.

In the early days of World War I, the British government sought to raise £350 million (about £38 billion in today’s money) through the issuance of “war loans.” Britain’s banks agreed to subscribe for £60 million and the BoE agreed to take £39.4 million on its books. The remaining £250 million was expected to be sold to the public by appealing to their patriotism. The issuance went ahead and the bond sale was heralded as a great success. The Financial Times reported on 23 November 1914 (clip below) that the Loan had been over-subscribed. It gushed – “by motives of patriotism no less than by thought of securing a good investment, the British Public has offered the government every penny it asked for – and more ….and still the applications are pouring in!”

Source: The Financial Times, 23 November 1914

The reality, however, couldn’t be more different. The public demand for “War Loans” was woefully low and amounted to a grand total of £91 million i.e. one-fourth of the amount the government wanted to raise from the public by appealing to their patriotism. At the time, if this failure had become public knowledge, it would’ve crashed the price of existing UK sovereign bonds and endangered any future capital raising by the British government thus undermining its preparedness for what was to follow in the Great War. The BoE officials, therefore, hatched a plan to cover up the shortfall. The BoE’s then Chief Cashier Gordon Nairn, and his deputy, Ernest Harvey, bought the securities in their own names using the bank’s money and the bond holdings were classified as “Other Securities” on the bank’s balance sheet rather than as holdings of government securities. The British Government of the day led Prime Minister Herbert Henry Asquith and his Chancellor David Lloyd George then declared the bond issuance a success and hailed it as a sign of patriotic fervour among the British people. And you thought “Fake news” was something new?

In a secret memo to the then Treasury Secretary John Bradbury, economist John Maynard Keynes called the effort of the BoE to step in and buy the unsubscribed bonds for its own account as a “masterful manipulation.” Today, we, of course, call it Quantitative Easing (QE) and we don’t make any effort to hide the “manipulation.”

Additionally, the funds that were raised from the public came from a very small group of financiers, private individuals and shipping companies that were among businesses benefitting from surging war demand for their services. Half of all investments were for £200 or less i.e. most of the wealthy British would rather have put their country in peril than part with their money. Patriotism was not enough.

Every patriotism has its price and particularly in free, capitalist and profit-seeking economies such as the US and the UK where governments cannot coerce capital to act against their interest. Capitalists have no nationality or national interest and they tend to gravitate towards opportunities that offer the best risk-adjusted return. Unless of course you are a capitalist in Russia or China and then you do what the government tells you to.

I continue to believe that there won’t be a full-fledged trade war between the US and China as it is not in either one’s self-interest. Over the weekend we learnt that US President Donald Trump had reached a “trade deal” with Mexico. As we know, the talks between the US and Mexico appeared close to collapse many times during the past 12 months. China and the US are talking again and that’s a good thing. With 2Q’18 US GDP growth of +4.2% and historically low unemployment levels in the US, Trump must know he has a window to renegotiate a trade deal with China from a position of strength. However, he mustn’t forget that the window will not remain open forever. The strong GDP growth in 2Q is attributable to a pick-up in trade activity in advance of the implementation of tariffs and increased consumption on the heels of the recent tax cut. Tax cuts are one-time adrenaline shots. A shot that Trump cannot administer or afford at will. GDP growth is forecast to ease to +2.9% in the 3Q and +2.6% in the 4Q of this year. Quarterly growth is expected to average just +2.2% in 2019. Besides, China is rapidly diversifying its economy and its reliance on the US. A rising debt and a trillion-dollar deficit that the US faces can easily be exacerbated with tariffs and the window of opportunity could close sooner than Trump expects.

As Trump ratchets up the number of Chinese exports that he is willing to levy a tariff on, the Americans like the Brits in 1914 will be faced with a question – at what price patriotism?

Turkey’s crisis is not a systemic risk

The big news in markets recently has been Turkey. The Turkish Lira has depreciated by over -40% this year, the current account deficit has widened to -6% of GDP and inflation runs at over +15%. Whilst it’s easy to draw parallels with the 1997 Asian Thai Bhat crisis and fear for the health of Emerging Markets in general, the only commonality between the two episodes is that it was a period of big capital inflows and then outflows, but the underlying conditions in Emerging Markets today are very different.

Robust economic growth over last two decades, floating exchange rates, high foreign reserves, and greater transparency have reduced the need for abrupt adjustments. Low single-digit current account deficits and in some cases (South Korea, Taiwan, Hong Kong and the Philippines) surpluses, are insulating these economies and the risk of contagion has consequently been reduced. Turkey defaulting on its debt – private or public – is very unlikely to cause a repeat of the Emerging Market crisis we saw in 1997. The problem Turkey faces is of its own making. A sharp increase in credit growth and government spending, financed by short-term capital flows (70% of Turkey’s debt is denominated in US Dollars and Euros) led to a rapid worsening of its current account deficit and left it vulnerable to both the USDTRY exchange rate and outright funding risk. Turkey’s crisis is not a systemic risk.

Turkey, however, does pose a risk to the European economy through its links with European banks and geopolitics. Spain’s second-largest bank Banco Bilbao Vizcaya Argentaria (BBVA) is the most exposed bank in the European Union (EU). BBVA owns 49.9% of Turkey’s Garanti Bank, the second largest private bank in Turkey. Unicredit, Italy’s biggest bank owns around 40% of Yapi Kredi (YKGYO.IS), Turkey’s fourth-largest bank, through a local joint venture. ING, the Dutch bank has a fully-owned subsidiary in the country, ING Turkey. BNP Paribas, the French bank controls 72% of the Economy Bank of Turkey (TEB), partly through a local joint venture. HSBC operates HSBC Turkey in the country. Of these five European names, only BBVA looks at risk of any meaningful capital impairment from the economic situation in Turkey. Garanti accounts for around 13% of BBVA group’s earnings. Of greater concern are the implications on geopolitics. An economic meltdown in Turkey could easily spill over into Europe and cause further unrest in the Middle East thereby triggering a new wave of immigration to Europe. Wary of this risk, Berlin is now considering providing emergency financial assistance to Turkey.

Markets & the Economy

Other than Turkey, it has generally been a positive time in the markets if you were overweight US equities. The S&P 500 index hit a new all-time high and is now above the 2900 level. The US Technology index, NASDAQ is also trading at an all-time high and is up +17.5 this year. Meanwhile Europe’s flagship Euro Stoxx 50 Index is down -1.8% and the MSCI Emerging Market Index is down -7.6%. The chart below details the performance of other key Equity Indices.

The Federal Open Market Committee (FOMC) minutes released for the July/August meeting was very upbeat and signalled more rate hikes this year. Last week, US Federal Reserve Chairman Jerome Powell, speaking at the annual symposium in Jackson Hole, Wyoming defended the Fed’s strategy of gradually raising interest rates even as he was criticised by Trump for moving too quickly. Powell reiterated his view that gradual hikes in rates will be needed as long as the economy remains healthy. “There is good reason to expect that this strong performance will continue” he said. At a fundraising event the week before last, Trump remarked that he was “not happy” about interest rate increases which the he feared would cool off the fast-growing economy. Before Trump, the last President to publicly call for lower interest rates1 was George H.W. Bush during his re-election bid in 1992. Bush later blamed then Fed Chair Alan Greenspan for his election defeat and said – “I think that if the interest rates had been lowered more dramatically that I would have been re-elected President because the [economic] recovery that we were in would have been more visible. I reappointed him [Greenspan], and he disappointed me.” Before that in the 1970s, political pressure on former Fed chairmen William McChesney Martin by the then President Lyndon Johnson and later on Arthur Burns by the then President Nixon (before his 1972 re-election) led to inflation surges as rates were kept low. The Fed later came to view these as a costly mistake. I do not expect the Fed to yield to political pressure and make the same mistake. The Fed has raised rates twice this year, most recently in June to a range between +1.75% and +2%. I expect the FOMC to raise rates by +0.25% when they meet in four weeks’ time.

Last week also saw headlines – “The end of Greece’s marathon bailout.” Only in the EU could a bailout be described as ended by completely ignoring the over €330 billion that has to be repaid by 10 million people who don’t like paying taxes. Euphoria in Brussels and official press releases rushed to claim Greece had exited its multi-year bailout program and it was once again a “normal” country. If only that were true. Taxes and regulatory burdens put on Greece as part of the bailout program have made growth unstainable and economic prospects still remain grim. Besides the Value Added Tax (VAT), small business tax rates, fresh pension cuts and new punitive income tax rates for the poorest are all scheduled for 2019. The charade of interest payment deferrals and extending the maturity of the debt can only go so far. Give it a few months and Greece will be back in the news seeking a fresh bailout. Greece is like Groundhog Day but without the happy ending.

The European Central Bank (ECB) has said it expects to phase out its bond-purchase programme by the end of the year, although it has also signalled that its policy rates, which include a negative deposit rate, would stay where they are at least through next summer i.e. the gulf between the ECB and the Fed policy rate will only get wider. The Eurozone still needs stimulus whereas the Fed plans to press ahead with raising rates. I am not bullish on the Eurozone growth and don’t see how the ECB will be able to end its QE policy this year in face of a growth slowdown and the fear of Trump tariffs hanging like the sword of Damocles over the head of the EU.

I continue to remain Underweight Europe and overweight US equities with a bias to Technology (XLK), Healthcare (XLV), Consumer Discretionary (XLY) and Financials (XLF). However, in Europe, few stock-specific trades are still worth holding or adding to. Luxury stocks like Louis Vuitton Moët Hennessy (LVMH) and infrastructure and industrial stocks (Vinci, Eiffage, Siemens, Bouygues) offer a good investment opportunity for completely different reasons. The world’s well-heeled shoppers are doing just fine and are unruffled by trade fears as they continue to splurge on handbags, jewellery and fine wines. Revenue at LVMH in the first half of this year hit €21.8 billion, up 10% compared with the same period a year ago and net profit jumped 41% to €3 billion. The case for industrial stocks is boosted by the urgent need for Europe to upgrade its infrastructure in the light of the catastrophic bridge collapse in Genoa. French President Emmanuel Macron is under pressure to step up spending on infrastructure after a government report warned that approximately 840 road bridges in France are in danger of collapse.

I was on Bloomberg TV last week for an hour discussing my views on Brexit, the US economy, European Banks and the crisis in Turkey. You can watch it at this Bloomberg Surveillance link (skip to 57 min).

In terms of other stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IMB US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Netflix (NFLX US), Twitter (TWTR US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US)

1 Greenhouse, S. (1992, June 24). BUSH CALLS ON FED FOR ANOTHER DROP IN INTEREST. The New York Times. Retrieved from https://www.nytimes.com/1992/06/24/business/bush-calls-on-fed-for-another-drop-in-interest.html

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital

“To be ignorant of what occurred before you were born is to remain always a child.”

Summary

Although China may be the most recent example of mercantilism/protectionism, if one were to look at the timeline going back to the 18th Century, it is the US that is the most protectionist nation. The US became the dominant economic power in the early 20th Century by having high protective tariffs and this served as a model for later day mercantilists – Germany, other European nations and most recently, China. George Washington, the first President of the United States, not only supported the protection of infant US industries, but also set an example by “buying American.” The US Presidents that followed Washington carried on the protectionist policies as they built America in the 19th Century. The Republican Party dominated the US politics from the Civil War (1861-65) to the Great Depression (1929-39) and were overtly protectionist. America’s commitment to a “free market” is a relatively recent phenomenon. Post 1945, America achieved the status of an unrivalled superpower and found itself in total control of the markets with a ravaged Europe and Japan and an Asia too poor to offer any challenge to its hegemony. With no threat in sight and the vast world economy to sell goods and services to, America discovered a love for a “free market” purely out of self-interest. History is a great thing. One just has to look back far enough to cure one of all prejudices.

American Protectionism

Let’s face it, there is no such thing as “free trade”, only good or bad trade deals. The debate about “free trade” and capitalism can be neatly divided into two distinct camps – Liberalism and Mercantilism. Liberals see the State as predatory and Business as profiteers and the two shouldn’t be allowed to work together to the detriment of the individual consumer. Liberalism places the individual’s interest at the heart of economic policy-making, with the objective of increasing household consumption i.e. giving the individual consumer easy and unhindered access to the cheapest possible goods and services. Mercantilists, on the other hand, don’t see this separation between the State and Business as a necessary condition to benefit the individual consumer. They see the two as allies and emphasise that the aim of economic policy-making is to improve the productive capacity of the nation in pursuit of economic growth, power and independence. For the Mercantilist, a sound economy requires a sound production structure within the nation and not a cheap production structure abroad. Mercantilists believe that a robust domestic consumption can only be underpinned by high employment at appropriate wages and not cheap goods from abroad. What does the Liberal like to call the Mercantilist? A Protectionist. Although China may be the most recent example of mercantilism/protectionism, if one were to look at the timeline going back to the 18th Century, it is the US that is the most protectionist nation. It became the dominant economic power in the early 20th Century by having high protective tariffs and it served as a model for later day mercantilists – Germany, other European nations and most recently, China.

I often get a strange look from my friends and colleagues when I make the observation that America was a “protectionist” nation. Perhaps you are frowning at me now as well. However, please indulge me and keep reading.

From the time of its Independence, through the Civil War in the 19th Century and the Great Depression in the 20th Century, the United States of America followed a “protectionist” policy as it looked to get the better of Great Britain and establish itself as the dominant economy in the world. George Washington, the first President of the United States from 1789-1797, not only supported the protection of infant US industries but also set an example by “buying American.” He said – “I use no porter [ale] or cheese in my family, but such as is made in America.” Alexander Hamilton, President Washington’s Treasury Secretary and the founder of America’s financial system argued in favour of a national industrial policy that inspired the likes of American economic nationalists Daniel Raymond and the German-American economic thinker Georg Friedrich List. Raymond believed that the “protective tariff represented national interests and that it allowed for the nation’s people a leverage, and special treatment granted to them over foreigners” in the fields of domestic commerce and industry of the nation. List, whose vision of a united Germany with a protected market was realized later in the 19th Century, believed that “the cost of a tariff should be seen as an investment in a nation’s future productivity.”

The US Presidents that followed Washington carried on the protectionist policies, as they built America in the 19th Century. The Republican Party (led by men such as Lincoln, McKinley, Roosevelt, Harding, Coolidge and Hoover) dominated US politics from the Civil War (1861-65) to the Great Depression (1929-39) and were overtly protectionist. The US Economist Joseph Schumpeter called tariffs the “household remedy” of the Republican Party. It wouldn’t be too off base if instead of calling the GOP – the Grand Old Party, one called them – the Grand Old Protectionists. Tariffs were used both to generate revenues as well as to protect the American economy from British and European imports. President Franklin Roosevelt summed it up well when he declared, “Thank God I am not a free-trader. In this country, pernicious indulgence in the doctrine of free trade seems inevitably to produce fatty degeneration of the moral fibre.”

America’s commitment to a “free market” is a relatively recent phenomenon. Post 1945, America achieved the status of an unrivalled superpower and found itself in total control of the markets with a ravaged Europe and Japan and an Asia too poor to offer any challenge to its hegemony. With no threat in sight and the vast world economy to sell goods and services to, America discovered a love for a “free market” purely out of self-interest. It ran a trade surplus for over 30 years selling goods and services to Europe, Japan and Asia whilst helping them re-emerge from the devastation of the Second World War. The love for “free trade” didn’t last long, however. The latter half of 1970s and early 80s saw massive capital outflows from the US and migration of manufacturing and this turned the US from a trade surplus to a trade deficit nation. As trade and budget deficits mounted and Japan achieved a rival status, America strong-armed Japan into signing the “Plaza accord” in a move to shrink the US trade and budget deficits. The US had a temporary respite and deficits began to narrow in the 90s until China came along. The accession of China into the World Trade Organisation (WTO) accelerated the US trade deficit as Liberalism (Clinton, Bush, Obama) won and Mercantilism/Protectionism lost. Now, the US is back to protectionism once again and once again under a Republican President, Donald Trump. China is accused of “protectionism” and the US is heralded as a “free trader.” History is a great thing. One just has to look back far enough to cure one of all prejudices. In that, I am reminded of this Marcus Tullius Cicero quote: “To be ignorant of what occurred before you were born is to remain always a child.”

From the US point of view, over three decades of liberalism have eroded its economic might and a return to mercantilism, as Trump proposes, is like a reversion to the mean. However, can this be achieved? Is the US ready to pay the price it will take to return to its mercantilist past? That’s the trillion-dollar question. If tariffs start biting US consumers, Trump’s “Make America Great again” could simply turn into “Make America Grate.”

Markets & the Economy

Things are stirring at the Bank of Japan (BOJ). Under its “yield curve control” (YCC) policy, the BOJ committed to holding 10-year yields at around 0%. This policy has been around since September 2016 and has been successful, thus far, in staving off deflation and keeping the Japanese Yen (JPY) weak. Over the weekend, there were reports that the BOJ was looking to move this target yield higher. That was enough for the market to sell the 10-yr Japanese Government bonds (JGBs) and yields spiked up by 10 basis points, which is a big move in Japan. The yield on 10-year JGBs rarely moves more than one basis point during a day’s trading. The BOJ had to step in to prevent more of a sell-off and it offered to buy unlimited amounts of the bonds at a yield of +0.11%. This had the desired result of preventing any more sell-off in the JGBs and in fact, the Central Bank didn’t wind up having to buy any bonds. The BOJ is trying to steepen the yield curve and help Japanese banks so they can in-turn boost the economy by making more loans. It’s a dangerous game, as the BOJ is nowhere near achieving its +2% inflation target and if the market interprets this as the BOJ being a step closer to unwinding its aggressive monetary stimulus – then the Yen will rally and undo years of BOJ stimulus. The BOJ is holding a two-day board meeting beginning on July 30. I do not expect a change in the YCC target and expect the BOJ to reiterate its faith in this policy.

On July 6, President Trump imposed a 25% tariff on $34 billion of Chinese exports to the US and threatened to impose a 10% tariff on another $200 billion worth of exports, if China retaliated. China shrugged off this threat and last week imposed a 25% tariff on the same value of US products— mainly agricultural products such as soybeans, cotton, beef, pork, dairy, and nuts. This week Trump indicated that he was willing to put tariffs on all $505 billion of goods the US imports from China. You’d think that risk assets would have reacted badly to this tit-for-tat trade spat. Not really. In fact, July has been a great month for risk assets. The S&P 500 index (SPX) is up +3.75% this month and continues the uptrend off the early April lows with a series of higher highs and higher lows (see graph below) as Q2 earnings have come in thick and fast, with the majority of them either meeting expectations or surprising to the upside.

S&P 500 index: Performance 2018 YTD

Of course, the effect of US tariffs on steel and aluminium, which came into effect on June 1, is showing up as well. Alcoa reported its Q2 earnings last week and it indicated that the recently enacted US tariffs on steel and aluminium are hurting its earnings. Only 14% of Alcoa’s global aluminium output is produced in the US. The rest is imported. The stock promptly fell -13% as the market started pricing the hit to Alcoa’s earnings from more expensive imports. General Motors (GM) reported Q2 earnings yesterday and while the net income rose the stock fell -7% on the unexpected high raw-material costs in the wake of US tariffs.

As I mentioned earlier, while imposing tariffs may be Trump’s objective of returning America to its mercantilist past, the success of this policy will depend on the price American consumers are willing to pay. Tariffs on the scale of $505 billion, would inevitably lead to chaos and price rises for everyday products in the US and the retaliation that would follow would hurt the US economy and US businesses. Regular readers of this newsletter will know that I do not believe Trump will sacrifice the US economy and go for an all-out trade assault on China, the US’s biggest and most important single nation trading partner. Wages in America are not rising fast enough and are growing at an annual rate of +2.7%. A tariff of 10% on everyday goods? Trump will have to be careful to not impact US consumers too adversely, if he wants to keep playing Marshall Will Kane in the movie High Noon out to save a town.

Trump’s protectionist bark is likely bigger than his bite, particularly with respect to the US trading relationship with China. The US is on target to run a $1 trillion budget deficit by 2020 and the national debt is heading to over +100% of GDP. The US can ill-afford the extent of deficit spending it would need in case of a full-on trade war with China without adversely and terminally affecting its future prosperity. I, therefore, continue to be overweight US equities, with a preference for Healthcare (XLV), Financials (XLF) and Technology (XLK) stocks.

Despite the “deal” that Trump and Jean-Claude Juncker, President of the European Commission, announced last night, I am wary of European equities. First of all, it’s not a “deal” but a start of a negotiation to get a “tariff-free” deal and to get rid of all “trade barriers and subsidies.” Secondly, there’s no timetable for progress and that is troubling given how long it takes for the European Union (EU) to negotiate even a simple trade deal. Third, have you ever seen a La Poste or a Gendarmerie car which was not a Renault, Citroen or Peugeot? I haven’t in over a decade of my travels to France. Protectionist France doesn’t have a trade imbalance with the US. Why then would President Emmanuel Macron of France agree to remove all “tariffs, barriers and subsidies” and open the French market to competition and pick a fight with the powerful trade unions in France? His closet is already full of troubles and his popularity is sinking like a lead balloon. Finally, to understand Trump’s motivation to slap a tariff on autos you have to understand the US auto market and what it means for Trump and the US rust-belt economies.

The US auto market recorded annual sales of 17 million vehicles in 2017, of which just 4 million were produced in the US. Trump wants the US to stop importing 13 million vehicles each year and force its manufacturers to produce them in America, creating manufacturing jobs in the hollowed out American rust-belt. In that, Trump is taking a lesson from China which imports less than 1.5 million of its annual 28 million auto sales. Therefore, I will believe an EU-US “free trade” deal on autos and other industrial products when I see it. With crucial mid-term elections ahead, Trump only wants cover for his attacks on China that have brought about the tariff on US agriculture exports to China. To alleviate the pain inflicted by that tariffs on US farmers, Trump had to announce a $12 billion subsidy this week. Europe buying soybean and liquefied natural gas (LPG), at least until the mid-term elections, plays into Trump’s hand and he looks magnanimous as US farmers offload their soybeans in Europe. Post mid-term elections, he can beat up on the EU again, as public opinion will be behind Trump riding high on his mid-term success. I see this EU-US truce as temporary, and hostilities will renew post mid-term elections.

Emerging Markets have taken a beating thus far this year as the US Dollar strengthened. The MSCI Emerging Market ETF (EEM US) has underperformed the SPX by more than -10% and is due a catch up as sentiment improves and the USD rally halts. There is also the stimulus from China. At a meeting led by Premier Li Keqiang this week, the State Council, China’s cabinet, vowed to use more proactive fiscal policies to spur growth. I would however not recommend a long position in Chinese equities traded onshore, but instead would recommend the large cap Tech names that trade on US stock exchanges – Alibaba, Baidu, Tencent and JD.com. Semiconductor stocks such as Micron Technology (MU US) are another favourite of mine. China accounted for more than 50% of Micron’s revenue in fiscal 2017. The stock was hit hard due to fears of tariffs but that seems to be easing. The stock still trades at under five times forward earnings estimates and could double over the next 12-18 months.

As for Financials, which have had a bad run this year, the Q2 earnings came in strong with Q2 profits rising +16-20% year-over-year. Yet, bank stocks – JP Morgan, Bank of America and Citi – have not been well bid. This is a mistake. Results showed that demand for loans remains strong. The latest US Federal Reserve data, for the week ending May 2, shows total commerical and industrial loans outstanding up +3.1% from a year earlier, compared with +0.9% at the end of January. This is still lower than the robust growth of +10.6% and +6.5% in 2015 and 2016 respectively, but clearly way better than just+ 0.7% in 2017.

In terms of other stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), Amazon(AMZN UW), Salesforce (CRM US), Home Depot (HD UN), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Vinci (DG FP), Pepsi (PEP US), LVMH (MC FP), General Electric (GE US), Activision Blizzard (ATVI US), Netflix (NFLX US), Twitter (TWTR US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US)

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

Summary

Society is a three-legged stool where each leg – economic, political and social – has to hold for the stool to stay upright. We often spend too much time and too many resources analysing and reporting on the economic and political legs, forgetting that the social leg is just as important, if not more so. Unaddressed, or wrongly addressed, social concerns have a tendency to creep up quietly and overwhelm societies – Brexit, Trump and the populist movement sweeping across Europe are good examples of this. German Chancellor Angela Merkel is finally in political trouble, not for economic mismanagement, but for her immigration policies. How fast the tide turns! When Merkel opened Germany’s borders to thousands of asylum seekers three summers ago, people in the affluent state of Bavaria rushed to help in such great numbers that authorities had to briefly turn back offers of clothing and food. It’s the same Bavaria now that has become Merkel’s Waterloo. The Christian Democrat Union (CDU) and the Christian Social Union (CSU) have formed a common group in the German Bundestag since 1949. However, this 70-year partnership that has provided leadership to the Eurozone over last two decades, is now at a breaking point. For the European Union (EU) and the Eurozone, the only thing worse than a strong Germany is a weak Germany. With the exit of Merkel, the EU would be robbed of the only political leader who appears to have the stature and experience to hold the bloc together, as it stumbles from one crisis to the next.
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“The individual has always had to struggle to keep from being overwhelmed by the tribe. If you try it, you will be lonely often, and sometimes frightened. But no price is too high to pay for the privilege of owning yourself.”

Summary

Italy, the beating heart of the European Union (EU) has gone from being a cheerleader of the Euro to a vociferous opponent. The market has taken note of a potential crisis brewing in Italy as a new populist government takes office. The yields on the Italian sovereign bonds (BTP) are rising and if you are looking to insure against a default, you will have to pay more to protect yourself against default on Italian bonds than Russian government bonds. That’s because, at €2.3 trillion, Italian sovereign debt is 132% of Italy’s GDP. Italy’s problems are lack of growth, shrinking industrial production and the absence of independent monetary policy levers to handle these. Since the peak of the financial crisis in 2008, Italy has lost over 9% of its GDP and a quarter of its industrial production. The average annual rate of growth per head in Italy, since the adoption of the Euro in 1999, has been zero. Therefore, an Italian born in 1999 who just turned 18 and has become eligible to vote for the first time, has seen nothing but economic stagnation during his lifetime. Yet, Italy is no Greece. Italy’s GDP at €1.7 trillion is ten times that of Greece. Italy runs a current account surplus, a healthy savings rate, and is a net contributor to the EU budget. Italy can not only survive outside of the Euro, it can thrive. The European Central Bank is nearing the technical and political limits of Quantitative Easing, and the growth in the Eurozone is slowing down. If yields keep rising and growth doesn’t pick up, it is likely Italy will relapse into an insolvency spiral. If Rome is then asked to submit to austerity for a second time, it will likely take matters into its own hands. The Euro experiment, therefore, may be nearing its end.
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“There are two kinds of forecasters: Those who don’t know, and those who don’t know they don’t know.”

Summary

In the 1930s, for over eight and half years, the US ran a trade surplus. Presumably, had Donald Trump been US President at the time, it would have made him a very happy man. Or maybe not. The 1930s will be remembered for the Great Depression, the worst economic downturn in the history of the industrialized world. President Trump likes to blame “tariff barriers and unfair trade practices” for America’s trade deficit. However, the key issues that are prevalent in the US since the 1980s, are a high domestic consumption rate, a low savings rate and a low investment rate. America has a deficit because it consumes more than it produces and spends more than it earns, both privately and as a nation. The obsession that every country’s policymakers has with running a trade surplus ignores one basic reality: All governments cannot run a trade surplus. For every surplus, there has to be a deficit. For the sake of the US Dollar and the US itself, Trump should focus on the budget deficit and the national debt and not obsess excessively with the trade deficit. If the recent tax cuts fail to accelerate US growth, let alone reach +4% as Trump has suggested, the deficit will soar and make fiscal conditions worse. How long will foreign investors then continue to finance the US deficit? Every indebted economy has a day of reckoning. For the US the risk may not be immediate but it certainly is rising. It was debt that caused the UK and Sterling to lose their crown to the US and the Dollar. The enormous post-war balance of payments deficit was just too much for the UK. Debt had taken its toll.
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“What kind of society isn’t structured on greed? The problem of social organization is how to set up an arrangement under which greed will do the least harm; capitalism is that kind of a system.”

Summary

From haggling over the price of tea on a quayside in Guangzhou in 1784 to trading in electronics and t-shirts today, over the course of more than two centuries, trade between the US and China has grown beyond imagination. This trade relationship is now the most significant in the global economy.

The world’s two largest economies account for 40% of global GDP, a quarter of all exported goods, and 30% of the world’s Foreign Direct Investment (FDI) outflows and inflows. Their fates are inextricably linked. In a way, they complement and need each other. The US cannot compete with China when it comes to manufacturing and China cannot compete with the US when it comes to product design or research and development capabilities.

The world’s most cost-competitive and largest electronics industry supply chain is in Shenzhen, China. China’s manufacturing capacity is so well honed and organised that it accounts for more than 25% of global manufacturing. It is my firm belief therefore that there will be no US-China trade war on the scale that may worry us all – and tariffs are just a negotiating tactic, albeit a necessary one. I see China opening itself up more to US exports. The US-China trade deficit will start to close meaningfully when the prosperity of China’s middle-class increases and they demand services that the US can export to China. Therefore, it is not just in the US and China’s, but also in world’s interest, that a China –US trade war is averted
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“The more the State “plans” the more difficult planning becomes for the individual.”

Summary

Despite its high debt to GDP ratio, Italy’s main problem isn’t that it borrows too much – the issue is its non-existent growth. Italy, the third largest economy in the Eurozone hasn’t grown in any meaningful way for over two decades. Tinkering on the edges and paying lip service to reform mean that the outlook isn’t very bright for Italy. The European Central Bank’s (ECB) easy monetary policy over the last five years, may have pushed the recent GDP growth rate in Italy to +1.5%’ but what will happen when the ECB winds down its Quantitative Easing program and interest rates begin to rise? A re-run of the rising sovereign bond yield and questions about the viability of Italy’s economy are bound to resurface. In terms of equity markets, I don’t believe we have entered a new market regime, despite the recent market move. We are probably entering a transition phase and despite the market rhetoric, it is premature to conclude that the US Federal Reserve is behind the curve. The steady rally up we have seen over recent years may be behind us and what we will see going forward are moves both up and down i.e. welcome back to the two-way market. I still expect the S&P 500 Index to notch an +8-9% return this year – at least 200 points higher from the current level. What I am more concerned about is the rapidly deteriorating political equation in Germany. For the first time, the Far-Right Alternative for Germany (AfD) party has now surpassed the centre-left Social Democrats (SPD) in a national poll. How long before the AfD becomes the largest party in Germany? Inconceivable one might say, but not impossible. As Angela Merkel has moved leftward to occupy the space formerly taken up by the centre-left, the AfD has little competition for anything right of centre.
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“You can easily judge the character of a man by how he treats those who can do nothing for him.”

Summary

That was a very brief US Government shutdown this week. It lasted two days. Not that I am complaining. The agreement reached keeps the US Federal government funded through February 8, but it does little to resolve the contentious issues of immigration and government spending. The deal doesn’t preclude a similar shutdown next month. Markets care more about economic data than political “noise” and the data continues to be good. On the back of US tax reform, US growth is expected to accelerate and hopes have risen of wage increases. Global GDP growth is set to accelerate to over +3.5% from +3% in 2017. The global output gap is forecast to vanish in 2018 – the first time in a decade. The International Monetary Fund (IMF) estimates that, last year, 150 out of 176 countries managed to increase their exports. That is the highest share of nations on record and slightly higher than the peak reached in 2005.

So what could go wrong? The answer is: Trade wars. We got a taste of it on Monday when the US slapped steep tariffs on imports of solar panels and washing machines. President Donald Trump now seems ready to start implementing his “America First” trade policy. Be prepared to see more such trade-enforcements in the coming months. As top exporters, Europe, South Korea, Mexico, China, and Japan are all vulnerable to US trade tariffs and the “America first” policy. However, if trade wars become a global “thing,” with nations responding with tariffs and counter-tariffs of their own in a free for all, then the European Union (and Germany in particular), Korea and Mexico are most vulnerable, given their higher reliance on exports.

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“Just because you do not take an interest in politics doesn’t mean politics won’t take an interest in you.”

Summary

2017 was yet another superb year for the S&P 500 (SPX) index and the eighth full year of the current bull market run that began in March 2009. However, sluggish wage growth in the US has been a consistent theme of this economic cycle, confounding many, who believe a falling unemployment rate should herald higher pay for workers. Hopefully, the proposed cut in corporation tax in the US will drive investments and hence wages. If corporations however, use the tax cut to buy back stock and pay a dividend (as many have done so far), the impact of the cuts on GDP growth will not be so dramatic as consumption fails to take off. Unless the coal miner in West Virginia or the single mother in South Side Chicago has more to spend, businesses will have fewer reasons to invest. This equity market Bull Run will only come to an end when the US Federal Reserve starts raising interest rates aggressively, as was the case in 2006/07 and the yield curve inverts. The rule of thumb is that an inverted yield curve indicates a recession in about a year’s time. Yield curve inversions have preceded each of the last seven recessions. On Brexit, a breakthrough last Friday in the gruelling “divorce” talks between the UK and the European Union (EU) has paved the way for talks on trade. The agreement has significantly reduced the likelihood of a “no deal” scenario when the UK leaves the EU in March 2019. Bitcoin was and still is a gamble. At this point all I would say is: A fool and his money are soon parted. A fool and his Bitcoin may take longer, but they will be parted.
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“Never appeal to a man’s ‘better nature.’ He may not have one. Invoking his self-interest gives you more leverage.”

Summary 

Angela Merkel has loomed large on Germany and Europe for the last 15 years, yet, if Edmund Stoiber had not lost the 2002 German election to Gerhard Schroder by the thinnest of margins, the world wouldn’t know of Merkel the way it does now. Merkel’s pro-migrant policy in 2015 divided the centre-right in Germany and fuelled the rise of the far-right, which entered the national Parliament for the first time after September’s elections. While Germany is clearly going to feel the pain of an unstable political environment, following the collapse this week of coalition discussions, the bigger casualties are the Eurozone and the European Union (EU) who have come to rely on a steady and stable Germany for leadership and direction. Without Merkel it will be like the EU has lost its “good shepherd”, as it deals with growing populism in Eastern Europe and with Brexit. There is little appetite in Germany for “more Europe.” Merkel’s stint as the “leader of the free world” has been very short-lived. A wise leader knows when it’s time to go. Does Angela Merkel?

In the US, the Federal Reserve (Fed) released the minutes of its last meeting. These confirmed what the market already anticipates – an interest rate increase at its next meeting in December. All eyes, however, are on the US tax reform Bill which, if passed, could alter both the growth and the inflation outlooks and push the Fed to raise rates more aggressively than currently forecasted.
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“Real knowledge is to know the extent of one’s ignorance.”

Summary:

The all-important 19th National Congress of the Communist Party of China (CPC) kicked off last week in Beijing. In his bold 3 hour and 23 minute address, President Xi Jinping, outlined the party’s priorities for the next five years. If Beijing has its way, China is on a track to becoming an economic power the likes of which we have not seen in a long time. It’s not the Japan of the 1980s, it’s much larger. It’s no surprise then that even the US National Intelligence Council warns that the era of Pax Americana is “fast winding down.” To the Western eye the ascendant power of Beijing may seem a disruption to the status quo, but to students of world history and China, it is the restoration of a millennia-long equilibrium. China was the biggest economy in the world for most of the past 2,000 years, only to be overtaken by Europe in the 19th Century. The ramifications of this Chinese growth are significant. America will almost certainly come out second best if it doesn’t change tack – with Europe a long way behind.
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“One of the symptoms of an approaching nervous breakdown is the belief that one’s work is terribly important.”

Summary:
Something remarkable happened two weeks ago. President Donald Trump, with the help of Democrats in the US Congress, managed to strike a deal on the US debt ceiling. An impasse on lifting the debt ceiling would have caused a disaster much worse than any hurricane. The agreement stunned seasoned political experts who, for years, had become accustomed to bitter partisanship and dysfunction in Washington. Trump showed once again that he does not belong to any party or ideology. He is in the White House to promote his legislative agenda and he is ready to make deals. If the establishment Republicans dislike this, then so be it. Trump likes to do deals. However, since this is politics, there will unlikely be a longterm Trump-Democrat lovefest. Democrats (and the media) will be back to hating Trump again quite soon. With the US debt ceiling suspended until mid-December, the major macro-risk for US equities has receded. As the hope for US tax reform is raised, it is hard to see what could stop the S&P500 Index (SPX) from continuing to climb till the end of the year. One main theme last week was better than expected inflation numbers in the US, the UK, China, and India.
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"There is always a well-known solution to every human problem — neat, plausible, and wrong."

Summary:
The financial markets seem very complacent regarding the looming debt ceiling debate in the United States. I am however quite concerned and anticipate a period of sustained volatility during September and October, as the debate intensifies. If the “debt ceiling” were not raised in time, the government would run out of money to pay interest on the debt, write Social Security checks and make millions of other routine payments. I don’t see the US missing payments on Treasury debt, as that would be catastrophic, however, I suspect missing payments on social security would also be not taken kindly and could send financial markets into a tailspin. US House Minority Leader Nancy Pelosi has called for passage of a “clean” debt ceiling bill without any conditions. You can be sure there are enough Democrats who want to extract concessions from the Trump administration and enough Republicans who want to cut federal spending – that this could thwart raising the ceiling in time. US Senate majority leader Mitch McConnell likes to tout he has his troupes under control, but as we all know, he couldn’t get Trump’s Healthcare bill passed. Nothing about the performance of this Republican Congress to date offers any reason for optimism that it can now deal with this issue. Beware a sell-off in risk assets starting mid-September, if not before.

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"There are no facts, only interpretations."

Summary:
The US unemployment rate, currently at +4.3%, has now hit a 16-year low and shows that the labour markets are tightening. However, wage growth is still stuck at a low level. The US Federal Reserve (Fed) is still faced with a disinflation problem. The European Central Bank (ECB) is not ready to commit to any timescale on tapering or to provide any “forward guidance” on it. In fact, there appears to have been very little debate at the ECB meeting last week about how much more easing may or may not be needed going forward. Recently the media has been abuzz with reports that central bankers in the US, Canada, the Eurozone and the UK had signalled that the days of easy money are nearing an end. Sounds like wishful thinking to me! The Fed, the ECB and the Bank of England (BoE) have all pulled back, after sounding hawkish temporarily. The easing bias is set to continue and, therefore, there is little risk of an equity market sell-off anytime soon. If President Trump could do anything to ease the regulatory burden that the US economy carries, it would be a big boost to the GDP growth. Americans spent an eye-watering $1.9 trillion in 2016 just to comply with federal regulations. If it were a country, US regulation would be the world’s seventh-largest economy, ranking behind India and ahead of Italy. The regulatory tab of the US is nearly as large as the total pre-tax profits of all its corporations.​

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"Big-government liberals don’t like people with a sense of independence – because independent people don’t need big government."

Summary:
In the rescue of two of its troubled banks – Banca Popolare di Vicenza and Veneto Banca, Italy decided to abandon the new European bail-in rules and instead “bail-out” these banks, at a cost to the Italian taxpayer of €17 billion. So much for new rules ensuring tax payers are never going to bail-out failing banks again! The European Union (EU) has once again failed to rein in bankrupt banks. Investors are watching and many are not impressed. The EU is no longer a bureaucracy, it has become an adhocracy that uses ad hoc rules which it makes up as it goes along. In the UK and the US, Labour leader Jeremy Corbyn and US Senator Bernie Sanders are suddenly the role models of the youth who are overcome with pangs of socialism. History suggests that every single truly socialist country has been an economic failure. Socialist nations make their people poorer, undermine democracy and endanger individual freedom. The poor in socialist countries have always done worse than they would have done under a capitalist economy. This lesson is sadly lost on the modern day youth in the western world. Frustration in the youth of today is understandable. People whose life hasn’t matched their expectations, often become alienated and angry. They were promised a better future and it looks anything but that.

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“Asking liberals where wages and prices come from is like asking six-year olds where babies come from.”

Summary:
Political passions are running high in Washington, and following the news that President Trump may have tried to coerce FBI director James Comey out of investigating Michael 
Flynn’s ties to Russia, the word “impeachment” has entered the US political lexicon once
again. But even with a handful of lawmakers eyeing this possibility, impeachment is still a long­shot. Trump is still very popular within his voter base and most Republican Congressmen owe their seats to Trump’s victory. A massive shift in public opinion across the country would need to happen in order to pressure Republicans in Congress to take on President Trump. If there is no evidence that implicates Trump, I suspect that this will be the media’s last hurrah and Democrats will suffer most for fanning wild speculation. Those rooting to see the back of Trump should beware of the fantasy that the nation’s problems would be solved if only Trump could be made to disappear. Millions of Americans still have legitimate concerns about everyday economic life. Middle America has seen its jobs disappear to technological change, local factories have closed, and towns and cities have lost their prosperity. Not recognizing thisas the bigger problem that faces America, displays a rudimentary misunderstanding of those

who voted for Trump. It would be foolish to say that a major scandal involving the President would have no impact on financial markets, but it would likely be temporary. The ultimate driver of the S&P 500 and financial markets over the longterm, is economic growth in the US and abroad and both these measures are holding up quite well.

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"Under capitalism, man tries to exploit man using voluntary exchange; under socialism, man exploits man using government force"

Summary:
Imagine an election in the US without a Democratic or Republican candidate. That’s what we have in the runoff for the French Presidential election on May 7. Emmanuel Macron, the favourite to win, will find that winning is the easy part. Despite Macron’s success in the first round, the death of populism has been greatly exaggerated. 48% of the votes in the first round went to candidates hostile to the EU and globalization, causes that Macron champions. On the one hand, Macron is not beholden to the Left and so, theoretically, is free to make decisions that are unpopular with them. There is hope that he will act unselfishly and not cave in to leftist sentiment. On the other hand, successive Presidents and Prime Ministers in France have announced their intentions to change and reform the country, only to be successfully opposed by those who have something to lose. UK Prime Minister Theresa May surprised everyone last week by calling a snap general election for June. With her party 23 point ahead in the polls, May is expected to win this election in a canter. May has called the election because the country is coming together, but Westminster is not. The Tories have long been written off as English right-wingers, winning only token representation beyond the English borders. Polls indicate that all this is about to change and the Tories are on track to becoming the formal opposition to the SNP in Scotland and the biggest party in Wales.

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"You can’t be for big government, big taxes, and big bureaucracy and still be for the little guy."

Over the weekend, President Trump failed to repeal and replace The Affordable Care Act also known as Obamacare. Obamacare, with a budget five times that of the UK’s National Health Service (NHS), is a prickly issue, and one which will unlikely be solved to everyone’s satisfaction anytime soon. Now the Republicans plan to move on to tax reform and have promised quick action. However, tax reform could be just as complicated as healthcare reform. To start with, the only actual tax plan in existence, the Ryan-Brady Border Adjustment Tax, is extremely divisive within the Republican Party and doesn’t have sufficient support to pass the Senate. The economic recovery and the equity bull market, that started in March 2009 are celebrating their eighth anniversary this month. During this time the S&P 500 Index is up a staggering +246%. The economic expansion has been driven largely by record low-interest rates, the lowest since the 1800s in the US, driven by accommodative monetary policy. Going forward, given the low level of interest rates and expectations of rising inflation and bond yields, equities continue to offer better potential returns than bonds. On a valuation basis, Europe looks much more reasonably valued than the US. The European Stoxx 600 Index is still -7% below its 2007 peak, whereas the S&P500 Index is +48% above its 2007 peak.

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"A great many people think they are thinking when they are merely rearranging their prejudices."

Marine Le Pen has set out her stall for the French Presidential election in April. Her “Free France” manifesto begins with a pledge to restore full sovereign control over the currency, the economy, laws, and the territory. Le Pen is the insurgent candidate and the two-round ballot election is her biggest hurdle to the prize she covets – the Presidency. Nearly the whole of the French establishment on the Left and on the Right unquestionably accept the European Union (EU) as France’s historic destiny. The Front National’s denunciation of the EU, therefore, makes it the shibboleth of progressive values. So to the important question, can she win? I say, yes she can. Le Pen’s second-round polling support has been rising in recent months, causing the financial markets to step back and take notice. Europe’s periphery debt market has welcomed a new member – France! President Trump plans to send to Congress an outline for a comprehensive plan to overhaul the tax code for individuals and businesses by the end of this month . If we go by his campaign promises, small and medium size enterprises will likely get a reduction in taxes and regulatory burdens. This will be positive for US growth and in turn for the markets. I recommend that you remain long risk and overweight US equities. There is a low risk of a US recession over the next 12 months and even a modest pick up in nominal growth should push global earnings higher. I do not expect a rate rise at the March Federal Reserve meeting. Present conditions don’t warrant it. I, however, do believe that President Trump’s policies are going to be reflationary and that they will bring the Fed into action. We will see it raise rates at least three times this year, with all three hikes coming in the second half of 2017.

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"Political correctness is tyranny with manners."

With Brexit and the election of President Trump, a new era is upon us. An era in which the certainties that have held true for decades are suddenly no longer valued. They are vulnerable. Globalization, immigration and liberalism which have defined the last three decades could get undone by protectionism, nationalism and populism. Yes, trade wars could be a reality and, yes, the US and China really could go to war in the next five years. No, their trade relationship will not prevent it. The UK­German economic relationship didn’t prevent the slaughter at the Battle of the Somme a century ago. However, there is a silver lining. The current populist wave in the US and Europe is not about “pitchforks and soak the rich” and potentially has a positive side to it. Unlike past populist movements that arose from a desire to upend society, today’s movement is driven more by the longing to restore things to the way they were in the “good old days.” In other words, it may have reactionary elements, but it is not truly revolutionary. The grievances if handled correctly, will pave the way for a brighter future. The markets are probably right to think that Trump heralds a friendlier approach to business, in the form of lower taxes and less regulation. The S&P 500 Index (SPX) has been flat since mid­December, as investors take a wait and see approach to the policies of President Trump and their impact on assets.

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"Too many of us are not living our dreams because we are living our fears.
"

On Wednesday, the US Federal Reserve raised the Federal­Funds rate by +0.25%, yet didn’t alter its growth and inflation projections much. Like everyone, the Fed is in wait­and­see mode as to the reflationary promises of the incoming Trump administration. If we look at the recent history of US recessions, on average, the US economy has experienced a recession every eight years. The current economic expansion, which started in June 2009, is now in its ominous eighth year. Almost everyone is of the view that Trump will have to deal with a recession or a financial crisis, at some stage during his term in office. The Fed knows that it needs to hike as much as it can in order to prepare for the next crisis. I would not be surprised if we saw another rate hike at the next meeting in January. As we look back at 2016, the big event was certainly Brexit. It signalled the rise of “populism,” which is now firmly entrenched in the UK, the US and across Europe. The post­Second World War principles of Social democracy (particularly in Europe) are having an existential moment and populist nationalism is in ascendance. President­elect Trump’s policies are largely a “basket of unknowables.” However, on the issue of trade, Trump has held a consistent view for a long time. At the core, Trump is a mercantilist, who believes trade deficits are bad for workers and the economy and that trade tariffs are one way to overcome them. My biggest fear for 2017 is that protectionism gains ground, first in the US, and then everywhere else in response. Much like the 1930’s, when the signing of the SmootHawley Act by another Republican President, Herbert Hoover, unleashed protectionism and the collapse of global trade. The well­being of the American people, and indeed the world, are predicated on the smooth flow of global trade and capital.

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"Gentlemen, I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves."

The last time a right-wing anti-establishment candidate made it to the White House was in 1829, when Andrew Jackson became the United States’ seventh President. The election of Donald Trump is repudiation of the liberal indifference to economic stagnation, income inequality and the diminishing economic prospects for American families, which have clouded over the US during the two terms of President Barack Obama. In Tuesday’s vote, Americans have refused to accept this status quo as the best the US can do. They longed for a leader who would not “manage the stagnation/decline” but fight to restore growth and “make America great again.” Voters rejected the progressive agendas of Hillary Clinton and Obama, much of which have stifled economic growth for the past eight years with over-regulation and legislative gridlock. If Trump is wise enough to surround himself with clever advisors and follow the example of President Ronald Reagan, who adopted the reform agenda that former Congressman Jack Kemp and other House Republicans had prepared, then don’t be surprised to see a +4% GDP growth in the US, late in 2017. The best market returns were generated under Republican Presidents working with a Republican controlled Congress. In that scenario, the S&P 500 Index gained +15.1% annually. Therefore, now that we have Republicans controlling the White House and Congress, US equities will be a good medium to long term play. However, one has to be patient, since “President” Trump, will not be in office until January 20, 2017 and the rally in equites will not be sustainable until GDP growth accelerates.

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"The poor have sometimes objected to being governed badly; the rich have always objected to being governed at all"

Italy is a sorry shadow of its former self. Italy’s economy has shrunk by approximately 12% since the financial crisis of 2007. Overall unemployment is 11.5% and youth unemployment stands at 36.5%, far above the Eurozone rate of 20.8%. Italy was not always in such bad shape. Between 1950­70, Italy was a powerhouse of economic growth and in 1987 its GDP passed that of the UK, an event termed by the Italian press as “Il Sorpasso” (Italian for “the overtaking”) and prompted wild celebrations in the streets of Rome. However, over the last two decades, Italy’s economy has essentially stagnated. Is the Euro to blame for Italy’s current economic mess? Only partly, in the sense that a weaker currency would certainly help Italy grow faster, create more jobs and provide the favourable backdrop needed to carry out unpopular reforms. The Euro may have made the Italian economic situation worse but it certainly isn’t the root cause. On the other hand, years of rampant corruption, lack of reform on the labour, judicial and economic fronts, most certainly are. What Italy needs is a “Yes” vote in this Sunday’s referendum. What it will likely get is a “No”, more upheaval and surprises that will threaten the Euro and the foundation of the European Union in the years ahead.

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"In our personal ambitions we are individualists. But in our seeking for economic and political progress as a nation, we all go up or else all go down as one people."

Hillary Clinton is now favourite to win the US election. If the US economy continues to grow at a pace of +1 to +2% per year (instead of the historical +3% to +4%), then the current economic and political problems will only worsen. Clinton will be acutely aware of this. A growth deficit should be a bigger worry than a budget deficit. Fiscal austerity has to give way to fiscal spending that induces growth. With 30y US Treasurys yielding 2.5%, borrowing to invest should be the mantra. The current economic expansion in the US, which began in June 2009, is now in its 88th month, which means that Trump or Clinton is likely to face a recession early in his or her administration. Equity Bull markets tend to have an expiration date as well: On average every 4.5 years. However, like the economic expansion, this Bull Run is also past its due date and is now seven years old. Does that mean one should sell? Not at all. Seasonally, we are entering the best period for equity markets. November to April is when equities tend to do well, before the May to October swoon. Since 1950, the S&P 500 Index has gained +7.1%, on average from November through April, versus +1.4% from May through October. Monetary accommodation is set to continue. These markets will not be broken by central banks. In many respects the central banks “own” these markets. If anything breaks the market, it will be the upheaval that only politics can cause – the US election, the Austrian election, and the Italian constitution referendum amongst others.

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"Facts do not cease to exist because they are ignored."

While bond yields have risen recently, to me, this looks like another episode of “taper tantrum,” where bond prices are recalibrating to prepare for a (perceived) less aggressive monetary policy. In the developed markets, low growth and subdued inflation outcome/expectations mean monetary accommodation is set to continue. Bond yields will remain low until such time as the global economy is back to its normal growth rate. If that takes another decade, then so be it. At least in the Eurozone and Japan, I see bond yields remaining low for the foreseeable future. These markets will not be broken by central banks. In many respects, the central banks “own” these markets. If anything breaks the market, it will be the upheaval that only politics can cause ­ the US election, the Austrian election, and the Italian constitution referendum amongst others. One aspect of monetary policy accommodation which hasn’t worked, is the negative interest rates policy (NIRP). Lower rates have a depressing effect on household incomes, through reduced interest on savings and pensions. To my mind, NIRP will, in due course, be seen as a major policy error and the BOJ specifically, has painted itself into a corner. With respect to the FOMC meeting this week, I believe it will be a very close call and should we get an interest rate hike, it will not spook the market and financial stocks should rally post hike.

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"Loyalty to the Nation all the time, loyalty to the Government when it deserves it."

As nominal growth has failed to accelerate, the supremacy of monetary policy and further accommodation is being put into question. This has led to renewed calls for “helicopter money” ­ or monetary finance ­ as a serious policy prescription. The implementation of such a policy would be contentious and concerns about any unexpected consequences to broader public confidence have kept even Japan’s more adventurous policymakers away from it. The fear that governments could use monetary finance to spend irresponsibly has some justification, but governments can just as easily spend irresponsibly in normal times as well. In fact, they do and they have. Monetary finance is one way to repair balance sheets and bring back new growth. The other is systemic default. Pick your poison carefully. Policy makers also need to concentrate on reforms of regulations and tax rules that currently favour short­termism over long­term capital stock building and higher productivity growth. There is a need for incentives to encourage real investment opportunities in both the private and public sectors. This will add to the tax base, reduce government expenditure and create more consumers. Despite the outperformance of traditional reflation plays ­ Emerging Markets (EM), commodities and the modest uptick in the performance of financial stocks, I do not believe that reflation is afoot for investors to stay overweight equities. I continue to advise to sell equities in a rally. The letup of the USD rally is the key factor driving EM and commodity assets.

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"When plunder becomes a way of life, men create for themselves a legal system that authorizes it and a moral code that glorifies it."

Modern banking was born in the Middle Ages in Florence, Italy. Florentine banks lent money to kings, emperors and popes. However, the current state of Italy’s banking system is a long way from its successful past and it is teetering on the brink of disaster. Italy’s banks hold bad debt to the tune of €360 billion, or 20% of the country’s GDP. So far, Italy’s efforts to reform its banks have been half­hearted and severely underfunded. Now PM Matteo Renzi wants to “bail out” the Italian banks using Italian taxpayer’s money. But the “bail out” falls foul of EU’s 2014 post­crisis “bail­in” rules for bank rescues which require bank bondholders to take haircuts on bank losses before taxpayers do. Renzi can ill­afford to “bail­in” pensioners holding their savings in Italian bank bonds. Therefore, a solution to the Italian banking crisis is a matter of political will, which in turn revolves around the German stance. I expect the austere Germans to “give into” Italian demands, if only to stave off a “systemic crisis” in the Eurozone. It’s too early to say how the EU­UK Brexit negotiations will go. The EU’s single market aims to guarantee the free movement of goods, capital, services and people among the EU’s 28 member states and German Chancellor Angela Merkel has so far indicated that she is not willing to negotiate concessions with this principle. However, in diplomacy everything is up for negotiation if conditions demand. A long delay in agreeing the terms of a EU­UK trade deal is going to be costly for both sides. I am hopeful good sense will prevail and a mutually acceptable solution will be found. I have now pushed out my US interest rate hike expectation from September to October and I still maintain that upside to equities is limited and one is better off buying on dips rather than chasing rallies.

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"A government big enough to give you everything you want, is big enough to take away everything you have."

The Brexit vote can be about many things but, at its heart, it’s a vote about the sovereignty of the national Parliament of the UK. Whilst those on the continent (particularly in peripheral Europe), may have come to trust Brussels more than they trust their national Parliaments, at least in the UK sovereignty is cherished and protected. In the eyes of a Brexiteer, the European Union (EU) undermines that sovereignty. I expect the UK to vote (albeit very reluctantly) to Remain in the EU. However, a vote by the UK to Remain should not be construed as an approval of “business as usual.” There was never a necessity for the EU to be anything more than a “free trade” alliance and one can’t deny that the EU’s reach has exceeded political necessity. Whether or not the UK leaves, change is coming. Globally, if loose monetary policy alone remains the saviour, then I am concerned that we may see the next recession in the US in the not so distant future, as job growth slows and drags down with it wages, capital investment and consumer spending. The Negative Interest Rate Policies (NIRP) being deployed by central banks, seem ill­judged and a waste of valuable time. Negative interest rates are simply a distraction from what must be done to accelerate growth. The demand has to be injected directly into the economy and not intermediated through the financial markets.

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"Everything you want is on the other side of fear"

Winston Churchill once said ­ “Each time we have to choose between Europe and the open sea, we shall always choose the open sea.

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"Everyone wants to live at the expense of the state. They forget that the state wants to live at the expense of everyone."

Only a few weeks ago the market was weighing the probability of a recession risk in the US this year. Today, sentiment seems to have vaulted to the other extreme and is anticipating an interest rate rise in June, a move, that until recently, had been considered all but off the table. I am sorry that the market will be disappointed. The US Federal Reserve (Fed) may, at best, use its June meeting to telegraph that the probability of a rate rise is increasing. I suspect that even in July the Fed may sit on the fence and only raise rates in September. Let’s not forget that the elephant in the room is China and its currency, the Chinese Yuan (CNY). The USD/CNY peg creates a direct link between China and US monetary policy. Of course, some will argue – forget about the Chinese. That strategy however, was tested in August last year and January this year, with messy outcomes. The Fed has seen the trailer and I doubt they want to now sit through the full movie during an election year. There are less than four weeks to go until the Brexit vote. It’s very likely that the UK will vote to stay in the EU. However, referendums are not merely a consultative exercise but often have big long term implications. The 2014 Scottish referendum is a case in point. Although the majority voted to remain part of the Union, the Scottish National Party (SNP) emerged with unprecedented dominance over Scottish politics. The EU referendum will see a rise in Euroscepticism in the UK and certainly within the ruling Conservative party. The result is likely to be a UK that attempts to be more assertive in its dealings with the EU for years after a vote to stay

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"Governments never learn. Only people learn."

With no policy change expected and no press conference scheduled at Wednesday’s Federal Open Market Committee (FOMC) meeting in the US, attention will be focused on the post­meeting statement. I expect the tone of the statement to be modestly upbeat as compared to the previous statement. With the March FOMC meeting, and the recent speech by US Federal Reserve Chair Janet Yellen at the Economic Club of New York, the Fed has changed strategy. It is now more cautious and more aware of global conditions and, as a result, don’t believe it will change this approach again so quickly. In my view, it is a close call between one or two interest rate hikes this year, with the first hike not coming until July at the earliest. The US economy has plenty of steam to continue expanding. On top of this, if the Democrats win the White House (and it’s likely they will), we will undoubtedly see fiscal expansion and increased government spending funded by a higher deficit and higher taxes. The S&P500 Index (SPX) above 2100 will beget volatility, since it’s within touching distance of its all­time high. I would advise not to be deterred by volatility and instead build new long positions in favourite stocks or Indices when the opportunity presents itself. If a Brexit referendum were to be held today, the Remain camp would win. Whatever the result on June 23, the Brexiters are not going anywhere, unless the Remain camp wins by more than 20 points or more, and that is highly unlikely. Low interest rates are making life challenging for Germany’s savers and politicians. German Finance Minister Wolfgang Schäuble, earlier this month launched an extraordinary attack, blaming ECB President Mario Draghi for the surprising success of the Eurosceptics in German state elections. Comments like these are very dangerous for the future of the Eurozone.

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"There is nothing new on Wall Street or in stock speculation. What has happened in the past will happen again, and again, and again. This is because human nature does not change, and it is human emotion, solidly build into human nature, that always gets in the way of human intelligence. Of this I am sure"

When the S&P 500 index (SPX) fell ­10.5% by early February, it might have seemed a tall order to believe that we would be looking at a positive finish for the quarter. This is exactly what has happened as the central banks of the world have renewed their focus on monetary easing, with the biggest single impact coming from the US Federal Reserve. Last week, Fed Chair Janet Yellen provided a “Spring bounce,” by sounding more dovish than anticipated. Yellen’s comments appear to have ended the bull run in the USD and given a boost to risk assets. The Fed has undershot its inflation target for so long that it’s not unimaginable that it would be willing to accept some inflation overshoot (when there is one) to make up for the loss. This means that the interest rate risk is only to the downside. Inflationary pressures will likely remain elusive, and if they do come, then the Fed will most likely tolerate them rather than hike interest rates too quickly to quash them. Did last month’s G­20 meeting in Shanghai come up with a secret currency accord? A “Shanghai Accord” to weaken the US dollar, help the global economy and give China room to rebalance its economy? If the second largest economy of the world, China, is going to make a transition to a more flexible FX regime, and the emerging markets of India and China are to be a pocket of strong GDP growth that the world desperately needs, then both a contingency plan and global coordination are key. Therefore, if there was a tacit deal at the G­20 last month to keep the US dollar from strengthening further, it is certainly comforting. A weak USD will also be a help to Emerging Markets as a whole. The US economy has plenty of steam left in it and should continue its expansion for at least another eighteen months, if not longer. We were always unlikely to see a US recession this year, and the Fed’s decision to stay dovish has pushed this likelihood back further

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"Despite a voluminous and often fervent literature on “income distribution,” the cold fact is that most income is not distributed: It is earned."

Lower for longer is the new regime for oil, barring a geo­political conflict that disrupts supply. Saudi policymakers perhaps remember the bitter lessons from the early 1980s, when Saudi Arabia cut its production to prop up prices in the face of rising supplies from non­OPEC producers. Saudi policymakers today are determined not to make the same mistake again. Whatever one may think of the whole Brexit issue, it is clearly a possibility and that begets uncertainty. There is no precedent of a nation leaving the European Union (EU). We therefore have no template for how EU­UK economic relations might be post Brexit. The EU started as an economic area, breaking down trade barriers. Few leaders in the EU or the UK would want to go back to the time of trade barriers. It will be mutually destructive and therefore unlikely. The current US economic expansion is almost seven years old. This may seem long and we are therefore hearing murmurs of a looming recession. However, this expansion is the worst ever in terms of per annum (p.a.) GDP growth. During 1910­30, when the US experienced one of its worst depressions, Real GDP grew at a +2.6% p.a. pace. During 2009­15, US real GDP has grown at a paltry+ 2.1% p.a., largely due to the absence of any meaningful fiscal response. In the past, fiscal stimulus has been an important component of a recovery post a recession. This time around, austerity has been the buzzword.

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"When we remember that we are all mad, the mysteries disappear and life stands explained."

We have just witnessed a period of intense market volatility. This time around, its effect is compounded by equity markets finding it hard to break off the link to plunging oil prices. In 2008, over­leveraged banks and over­leveraged households, combined with feckless supervision and regulation led to the market crash and the great recession which followed. Today, banks are healthier, households have greatly deleveraged and there are no real signs of a systemic bubble or malcontent on the scale of the 2008 mortgage­backed securities (MBS) crisis. If there is one thing which is of concern to me, it’s the lack of liquidity, as regulations have forced banks to move out of various businesses and placed restrictions on the use of their balance sheets. The developed world has a growth problem, a productivity problem, a disinflation (if not deflation) problem and a middle class income problem. As I wrote in my December newsletter, the fiscal response from governments to address these is missing and monetary policy is near exhaustion. This will lead to market volatility but, to be clear, this is not 2008 all over again.

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"Madness is rare in individuals ­ but in groups, parties, nations, and ages it is the rule."

There is evidence to suggest that the “middle class” has been massively squeezed over the last few decades, with more middle income families dropping into the lower income set and with less of the national aggregate income accruing to the middle class. This shrinking middle class has a vast impact on consumption and ultimately on economic growth, corporate profitability and inflation. When middle income families can no longer afford to buy the goods and services that businesses are selling, the entire economy is dragged down from top to bottom. In Middle America, Middle England, Middle France, and just about everywhere there is disappointment with the state of things and the free market economy. If left unaddressed, this could prove destabilising. Perhaps a little “redistribution of wealth” might improve the quality and quantity of economic growth—and reduce the demand for more aggressive state interventions (or even dare I say a revolution) later. So what will 2016 be like? In short, it will be more of the same: Low growth, low inflation and low asset price increases. The Fed may have raised rates and projected four additional +0.25% rate increases next year, but in my view, they will be lucky to pull off two increases. Disinflation (if not deflation) is the bigger fear. Viewing the current global economic malaise as cyclical, is a mistake, as there are powerful structural forces at work.

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"Our great democracies still tend to think that a stupid man is more likely to be honest than a clever man, and our politicians take advantage of this prejudice by pretending to be even more stupid than nature made them."

If the US Federal Reserve wants to meet its target inflation rate, it will have to ensure there is no “slack” remaining in the economy. The unemployment rate is still falling and that would indicate to me, there remains more slack in the US economy. Besides, if the Fed were merely waiting for it to be satisfied with job creation before raising rates, then it would have raised rates by now. However, normalisation of interest rates looms and the “new normal” will be quite different to the old normal. The crisis may be over and the US economy resuscitated, but it is permanently in a different place until such time as we see a fiscal response to address structural needs. An interest rate rise should not be feared. Rising interest rates can be the harbinger of a growing economy; an economy restored to its health. Economic expansion underpins corporate earnings growth, which is one of the most important drivers of long­term stock returns. The temporary selloff in equities when a rate rise cycle starts, has often proven to be a buying opportunity, as subsequent equity market performance has been generally positive

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"Have no fear of perfection – you’ll never reach it."

The European Central Bank’s ultra-dovish comments last week came as a bit of a surprise. Yet, the Euro’s appreciation of over 10% from its March lows is a big burden for the Eurozone‘s exporters to carry (particularly Italian and German), at a time when China is slowing down and world trade is contracting. As inflation remains moribund and “negative rates” become mainstream, sooner or later the US Federal Reserve (Fed) is likely to go down this path as well. What if negative deposit rates don’t bring back growth and inflation? Will central banks send cheques in the post directly to the people? Strangely enough a “cheque in the post” policy may do more to bring back growth and inflation than anything done so far by the central banks. Therefore, monetary policy is going to remain accommodative for quite some time, and in such a case equities will remain bid due to the lack of a substitute asset class with a better risk-reward tradeoff. It’s likely we will see a new high on the S&P 500 Index (SPX) before snow arrives. As for next year, one argument is that the SPX has never been up seven years in a row. This is true, but neither have we seen every major central bank easing at the same time, taking rates to zero and buying assets.

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"How do you tell a Communist? Well, it’s someone who reads Marx and Lenin. And how do you tell an anti-Communist? It’s someone who understands Marx and Lenin."

The US Federal Reserve estimates the “natural” rate of unemployment stands between 4.9% and 5.2%.The current rate of US unemployment is 5.1%. Monetary theory therefore dictates that interest rates must be raised. However, the Fed is in no rush to do this and forecasts the unemployment rate for 2016 to drop below this “natural” rate. It is therefore quite clear that monetary policy will be governed by concerns about financial stability and not by fears of inflation; as has been the case for the past few decades. Fed Chair Janet Yellen is truly biased in favour of “lower for longer”. I find it hard to believe interest rates will go up this year. My guess is you will see the first rate rise in the US in Q1’16. Additional Renminbi (RMB) devaluation is coming. However, crucially, as the last few weeks have shown, the People’s Bank of China has the capacity to keep the RMB stable. The Chinese government aims to stabilise GDP growth at “around +7%” by carefully increasing fiscal support via infrastructure investment. There is room given its relatively small share of overall fixed asset investment of 17.5% compared to the historic share of approximately 25%. Around 15% of China’s population are rural migrants living for at least six months in urban areas. By gradually being recognised as urban residents, they will become more likely to buy a property, send their children to school and become part of the Chinese urban consumption economy. Urbanisation and the growth of the middle class with spending power are ultimately the key to China’s transition to a consumption-driven economy. China’s fifth Plenum starts in two weeks time. Decisions made and political agreements forged there, should remove a key obstacle to business and government investment. I expect China’s data to reflect a positive turnaround by the end of this year and to firm up further in Q1’16.

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"Traders who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make the big money"

When the Shanghai and Shenzhen stock exchanges opened for business in December 1990, there were eight listed stocks with a combined market capitalization of USD 500m. By 2015, the two bourses had 2,800 listed companies with a total market cap of over USD 10 trillion. Once purely a socialist command economy, China, the Middle Kingdom, is now partially socialist and partially capitalist. China represents 15% of world GDP and outweighs every country in the world except the United States. Therefore, what happens in China matters. Yet, it’s worth remembering – Chinese equity markets are not the Chinese economy. Unlike in the Western world, where listed companies represent a large proportion of GDP, the free-float value of the Chinese markets is only about one third of GDP, compared with more than 100% in the US and the UK. Besides, less than 15% of Chinese household financial assets are invested in the stock market. US interest rates remaining at zero, at the margin, are now a net negative for the economy. The sooner we get the first rate hike this cycle, the sooner it would remove the uncertainty that a 25bp rise in short rates would spell doom for financial markets. I can’t help but think that the real problem in the stock market is not now. It is for later, when inflation fears abound and the Fed starts hiking aggressively.

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"Wisdom outweighs any wealth"

A North-South ideological divide in Europe is now out in the open. In one camp, the pro-austerity Northern Europe, made up of Germany and its allies, (Finland, Netherlands and Austria); and in the other, the profligate Southern Europe made up of Greece, Italy, Portugal and Spain. A creditor North and a debtor South: an intra-EU colonialism of sorts. The much-vaunted “European solidarity” is but a myth and the mutual interests are not moderating but reinforcing each other in polarised directions. I have long believed that Greece would stay in the Eurozone and my belief has always been predicated on the view that Germany would do whatever was needed and would bear the “cost” to preserve the Euro. Events over the last few weeks have made me question my view. The German position on Greece and its hard-nosed negotiation tactics surprised many. This crisis has exposed a fault line too: France and Germany do not share the same vision of Europe. Notwithstanding the fact that Greece secured a third bailout, I have now come to the conclusion that, on balance, the likelihood of Grexit is now higher than Greece actually staying in the Euro. A third bailout is by no means a carte blanche and there are many strings attached that could trip up Greece. Besides, a third bailout deal won’t prevent Greece from plunging into a deep recession this year and perhaps next.

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"In the end, more than freedom, they wanted security. They wanted a comfortable life, and they lost it all – security, comfort, and freedom. When the Athenians finally wanted not to give to society but for society to give to them, when the freedom they wished for most was freedom from responsibility, then Athens ceased to be free and was never free again."

For those who think Greece cannot be reformed, Grexit is an easy solution to propose, but not one without consequences for the Eurozone. It is right to say that Grexit is not a problem in the short term (indeed Greece is only 2% of the Eurozone’s economy), but it’s the medium term implications that worry Germany, the biggest beneficiary of the creation of the European Monetary Union (EMU). If a Grexit does happen, it will change the nature of the EMU forever and make the Euro unstable. EMU will not be a monetary union anymore but will become a fixed rate system like the Bretton Woods. The Bretton Woods system collapsed as it was a fixed rate system, and it came under increasing pressure in the late 1960s and early 1970s as policies pursued by the United States diverged from policies preferred by other member countries. An erosion of the EMU will be a bad outcome for Germany. Of course Germany will not do a deal at any price, but the cost right now is not too high to pay in exchange for guaranteeing the stability of the EMU. Therefore, I continue to believe there will be a deal. Greece, in turn, will be subject to severe reform, for its own good. Athens is finally accepting that raising revenue and cutting spending is its only route to survival.

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"Don’t limit a child to your own learning, for he was born in another time."

If Greece couldn’t manage the €750 million payment in May without raiding the reserve account at the IMF, it seems likely that they will struggle to make the even larger payments in June. No European help is forthcoming in the meantime. Therefore, either Greece agrees a deal and gets EU aid, or it defaults on its obligations come June. Even if Greece were to approve a deal, it is difficult to predict what becomes of the country in six month time. Would Greece reform and find itself on a path to renewed growth or would it sink further laboring under stringent measures and eventually decide to exit the Eurozone. The US recovery that began in Q3 2009 has seen US GDP expand at rate, well below that of previous recoveries. A slow recovery can be knocked off its perch very easily and the US Federal Reserve will be very cautious on signaling monetary tightening. The Q1 GDP print in Eurozone was at an encouraging +1.6% quarter-on-quarter, with stellar performances from France and Spain. In what is becoming a habit, last week China’s People’s Bank of China cut benchmark one-year interest rates once again and more measures to liberalise rates were announced. Equities are still a buy. If the Euro continues to appreciate, then moving from Eurozone overweight to equal weight will be required. Japan may take a breather, but there is more to come.

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"Our elections are free – it’s in the results where eventually we pay."

Greece could be nearing its own “Lehman moment.” Progress in negotiations with its creditors has been slow around such issues as pension and labour market reforms, the VAT increase, the privatization program as well as the 2015 primary budget surplus. For Greece, covering the primary budget target to make the current repayment schedule meaningful, will become increasingly difficult from mid-May onward. Greece is running on empty and the current level of Greek Credit Default Spreads indicates a 90% probability of Greece defaulting on its debt within a year. However, a political consensus to effectively eject Greece from the Euro is yet to form. On-going Quantitative Easing by the European Central Bank, the Bank of Japan as well as the reluctance of the US Federal Reserve to raise interest rates too soon, has meant that the cyclical momentum for developed market equities is still in place. The Eurozone has seen a good run of better than expected economic data these past weeks and there is a strong likelihood that the Q1 GDP report could register annualized growth of +2-3%. As for Emerging Markets, a repeat of “taper tantrum” is generally viewed as unlikely, given that the path of a US rate rise (when it comes), will be slow and one of gradual increases. The UK election looks like being the tightest general election for decades. With all the party manifestos published and TV debates completed, opinion polls suggest none of the parties will win the upcoming election. The two biggest parties— the Conservative party and the Labour party— are neck-and-neck in opinion polls, yet both are far from securing an overall majority. Prime Minister David Cameron recently said he would not seek a third term. If forecasts are to be believed, he will be lucky to serve a second one. Based on the current projections, an arrangement between Labour and the Scottish Nationalist Party is the most likely combination – adding 280 labour seats to the 50 seats of the Scottish Nationalists, which produces a House of Commons majority. Will it be Prime Minister Ed Miliband and Deputy Prime Minister Alex Salmond? Scary thought.

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"“Experience is not what happens to you; it’s what you do with what happens to you."

The dovish US Federal Reserve (Fed) has spread its wings, but it’s not looking for flight.The year 2014 was when the Fed stopped providing stimulus as it wound up its Quantitative Easing (QE) program, and 2015 will be the year when the Fed raises interest rates. I continue to expect a September lift off in rates. Dropping the word “patient” from its policy statement is bearish only in action and not in intent. US GDP is looking weak in Q1, retail sales are floundering and core inflation was up only marginally in January. Low oil prices and a strong US Dollar are both deflationary and core inflation is anticipated to fall further in the coming months. China is facing a stiff challenge to its growth. Chinese exports collapsed in the wake of the global financial crisis seven years ago and since then economic momentum has continued to slip. It reminds me of what a Chinese policymaker told me recently – when China faces its biggest challenges to growth, you will see some of the biggest and most improbable reforms. Reform of the State Owned Enterprises (SOEs) will be a major theme of Chinese policy this year. The case for Eurozone equities remains strong and this is also evidenced by the Citigroup Economic Surprise Index for Eurozone (CESIEUR) which has bounced from a – 50 reading in September 2014, to +40 today, and it outperforms the US index. Accelerated USD appreciation will hurt US earnings; and I would position a portfolio overweight European equities and underweight US equities.

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"Those politicians, professors and union bosses who curse big business are fighting for a lower standard of living”"

The Eurogroup ministers meetings concerning Greece have proven inconclusive and more talks are to be held this week. At these meetings, the biggest disagreement has been over whether Greece should request an extension to its existing bailout program, which runs out at the end of this month. Greece is opposed to the extension yet the creditors believe extending the program is the best way to keep Greece from defaulting until a more comprehensive deal has been worked out. Over the last few days, the risk of Greece exiting the Euro has increased and is now arguably higher than it has been since 2012. Despite the posturing, protracted negotiations and rising risk, I still believe that a deal will be struck. It is hard to believe that Greece would refuse some funding from creditors in exchange for some structural reforms that the government intends to deliver on anyway. If you think Greece is a macro risk then Ukraine is the epicentre of manifold macro risk, given the involvement of Russia and hawkish comments emanating from the US. Seasoned US diplomats and foreign policy experts are getting vocal about arming Ukraine. France and Germany are, clearly and very sensibly, opposed to such assistance. There is little doubt that arming Ukraine would be a bigger catastrophe than the “eastward expansion of NATO” has already proven to be. Therefore, it was heartening to read that after 16 hours of overnight negotiations last week, the leaders of Germany and France had brokered a renewed peace deal to end the conflict in Ukraine. The macro data in the US is looking better by the day, particularly on the jobs front. However, the forward-looking guidance on earnings looks weak. The US equity market, as a whole, is unlikely to register big gains immediately and looks to be suffering from fatigue after a six year Bull Run. Therefore, I believe that sector rotation and stock picking offer the better return potential until such time as the path and quantum of interest rate rises in the US are fully assimilated. Long term worries for Europe around productivity and growth remain but short-term improvements in news flow, a cyclical upside as well as relative undervaluation of European stocks, all point to Europe as a more rewarding overweight position than the US. If you start from a low base, even small improvements can mean big relative improvements, and this is what we are seeing and will see more of in Europe.

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"When things aren’t adding up in life, it is time to start subtracting”"

By pegging its currency to a fixed EUR/CHF rate in 2011, Switzerland became an adjunct member of the Eurozone. This was the case until last Thursday, when it suddenly decided to cut loose. With Switzerland, we now have an insight into some of the risks that might emerge should a strong nation i.e. a budget surplus nation (Germany) leave the Eurozone. What we also saw last week, was a major western central bank going back on its pledge; a pledge it had reiterated to hold only a week before. It should serve as a reminder to all investors that unconventional policies will not last forever and cannot be taken for granted. At the heart of the Greek crisis is “debt sustainability.” This means that if the cost to service the debt becomes higher than the primary budget surplus, Greece will never be able to reduce its debt and will head towards a sovereign default. Greece has received €252bn in bailout money since 2010. However, astoundingly, 90% of this amount has gone to service debt and interest payments to creditors, many of whom are in the core Eurozone countries. Only 10% of the bailout money has gone into public spending. The Eurozone economy has weakened considerably and due to political wrangling, the European Central Bank’s (ECB) response so far has been more words than actions. The ECB is behind the curve. Fortunately, as inflation expectations have worsened, the consensus on the Council has grown. Even Bundesbank President Jens Weidmann seems to have shifted his focus from opposing a Quantitative Easing (QE) program, to influencing its design and implementation. The ECB Governing Council meets this Thursday, and I expect the meeting to result in the Council announcing a QE program to purchase Euro sovereign bonds. European stocks could rally significantly post the QE announcement. An ECB QE is not priced into European stocks.

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"Success is getting what you want. Happiness is liking what you get"

The US economy added 321,000 non-farm jobs in November and 2014 is on course to be the best year for hiring since the 1990s. The oilmen of North Dakota and Texas have been hard at work fracking. In a surprise move, the Organization of the Petroleum Exporting Countries (OPEC), the guardian and keeper of oil prices has walked away, leaving the “goal” unmanned and oil bears are scoring goal after goal. I see Brent oil prices bottoming out near $60 per barrel. Last week we learned that the European Central Bank (ECB) now “intends” and no longer “expects” to expand the balance sheet to its 2012 level. We also learned that the ECB could launch a new stimulus package without Council “unanimity.” While falling oil prices are a bane for oil producers and sellers, they are a boon for oil consumers and oil importers – principally in Japan and the Emerging Markets (EM). US dollar strength remains a massive obstacle to crude stabilizing, therefore low crude oil prices will continue to be a tailwind for world growth. I see a volatile Q1 2015 for the market, with Greece being the spanner in the ECB works, and a strong US dollar causing EM disquiet. However, low energy prices combined with continued improvement in the world’s biggest economy (the US), will see the year end on a very positive tone. 2015 will be another year of growth and higher equity prices.

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"The future is already here – it’s just not evenly distributed."

If Mr. Market were anxious about withdrawal symptoms after the end of the US Federal Reserve’s Quantitative Easing (QE) program, it needn’t have worried. The Bank of Japan (BoJ), in an almost perfectly synchronized move, followed with a JPY10 trillion increase (or about 2% of Japan’s GDP) of its annual target for expansion of the money supply. In Europe last week, Mario Draghi, President of the European Central Bank (ECB), did a good job dissipating the confusion around the ECB’s willingness to do more for the economy. He reiterated that the ECB was in a high state of preparedness to provide further stimulus, if required to do so. He also added that, contrary to speculation, the Governing Council was “unanimously” (he used the word “unanimous” five times during the press conference) behind the goal of expanding the balance sheet. The US mid-term elections saw Republicans seize control of the Senate from the Democrats. This result has arguably reduced President Barrack Obama to a “lame duck.” His policies have been repudiated, and it’s now up to him if he also gets “plucked.” Should Obama choose to negotiate and broker a deal with the Republicans (rather than use executive orders to govern), many things could be achieved and this will be positive for the US economy as well as the US equity market. All is not lost with Republicans controlling both Houses of Congress in the US. The last time this happened was in 1994 under President Bill Clinton, when the S&P 500 Index gained +25% during the ensuing 12 months.

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"Courage is what it takes to stand up and speak. Courage is also what it takes to sit down and listen"

From the European Central Bank (ECB) announcement last week, the market was left with the impression that the ECB Governing council has had a rethink and wants to see the impact of the existing policy initiatives before undertaking any fresh intervention. This however doesn’t change my view that the ECB will eventually pull the trigger on sovereign debt Quantitative Easing (QE) sometime next year. In the absence of more supportive news from central banks, it is easy to see how we might enter a liquidity vacuum over next two weeks, until the US Federal Reserve meets on October 29. This is the period of anxiety for equity investors. However, given all the bearishness during the last few days, markets were left confounded this week as to whether the minutes released by the Fed were actually from its meeting in September. The minutes were more dovish than the statements and comments of three weeks ago. In the present circumstances, being bearish or bullish comes down to basically one argument. Given the debt dislocation, if governments have to choose between inflation and deflation, which would they choose? If you vote for deflation, then you should be a Bear and a buyer of bonds. If on the other hand, you think inflation will be tolerated (and perhaps encouraged), then you should be a buyer of nominal assets – equities, real estate and commodities. The current disinflationary spell may threaten to bring on deflation but deflation is unlikely to be tolerated by the G7 central banks and governments. On a medium to long term basis, I am firmly in the inflation camp and therefore a buyer of nominal assets.

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"It is never too late to be what you might have been"

Last week, the European Central Bank (ECB) sent a strong and resolute message to fight dis-inflation by cutting its main lending rate, the deposit rate as well as pre-announcing the purchase of asset-backed securities. This could imply a potential expansion of €1 trillion in the ECB balance sheet, which could provide a boost to the outlook in the Eurozone for the next few months. ECB President Mario Draghi has once again bought time, and both European equities and bonds have responded positively. For much of the year, markets have been ignoring the referendum vote in Scotland, but not anymore! On Sunday, the complacency was broken, when the UK woke up to the shock news that the Yes campaign was now marginally ahead in the polls for the first time. A Yes vote in Scotland may have repercussions not just for the UK, but further afield as well. It could provide a catalyst to other discontented regions in continental Europe. The August selloff in the equity markets was short-lived and the month ended with a new record high. Recent data in the US has surprised mostly to the upside. An improving geo-political picture in the Ukraine, accelerating US growth and the unveiling of a stimulus program in Europe, all keep me positive regarding equities. I would not rule out a short period of market weakness around the US Federal Reserve meeting later this month. However, any sell-off would be a buying opportunity. The drivers for positive movement in the equity markets are central banks and seasonality, which in my view, would see the risk asset rally to the end of the year.

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"“I would never die for my beliefs because I might be wrong"

The message that the “US Federal Reserve is behind the curve” is resonating with some investors, who fear 1970’s like inflation is making a comeback. I personally believe that inflationary outlook is benign and will likely stay as such. The high inflation witnessed in the 1970’s was underpinned by three key factors – GDP growth averaged 4-5%, the unemployment rate was as low as 3.5% and, most crucially, the labour force was highly unionized. In a unionized labour force, wage increases are easily met and indeed passed on by the producer to the consumer, in the form of higher prices at the till. Over the past fifty years, the power of unions has been greatly reduced in the US. Italy is in a triple-dip recession due to lack of reforms. Lack of reforms scare off new investors, as well as stop existing investors from spending. Italy’s “significantly low” level of private investment is a direct consequence of the absence of reforms and the lack of clear government policy and is not due to the cost of capital. The ECB has intensified preparatory work related to outright purchases of Asset-Backed Securities (ABS). The ABS purchase rhetoric from the ECB raises the likelihood of it actually happening. In my view, the risk light on equities is still green but with some flashes of amber. I remain bullish on equities until at least the September Fed meeting and will then reassess. The comments from this meeting will help me decide if the light goes from amber back to green or from amber to red.

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Last week saw one of the strongest US jobs data reports since this recovery started in 2009. However, the unemployment rate of 6.1% (now only marginally off the 20 and 60 year average unemployment rate of 6.0%), masks a very soft labour market. The continued growth of part time jobs reflects the structural challenges and changes to the US economy. The equity rally has continued unabated and there’s still time to participate in the rally. The Federal Reserve views the totality of the labour market and not simply the headline unemployment rate or the stock market index to determine future policy. Price to Earnings (P/E) expansion can see stocks rise even if earnings lag and play catch up. We have seen this in Europe and the US over last two years. In the Eurozone the reduction in Public Investment is proving to be a major drag on growth. If this were to continue, the Eurozone runs the risk of falling into a new lower trend growth rate. Last week, European Central Bank President Mario Draghi reiterated the ECB’s accommodative stance. Emerging Markets will be a bigger story in the second half of this year. The new government in India will push on the infrastructure and manufacturing front to build the capital stock, meet energy needs, and herald much needed supply side reforms.

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"Success is getting what you want. Happiness is liking what you get"

Mario Draghi’s “whatever it takes” pledge in July 2012 came at a time of extreme market dislocation and it completely changed the market’s expectations. Last week, in another unprecedented move, the European Central Bank (ECB) cut the overnight deposit rate to below zero and announced a new round of liquidity inducing measures. The ECB has a tough job to change expectations for future growth and inflation and this is where the challenge lies. For now, Draghi has done enough to buy time and keep deflationists at bay without announcing an overt Quantitative Easing (QE) program. In the US, house prices have risen, the Standard & Poor’s (SPX) 500 index has tripled from its 2009 lows and the US has recouped all of the 8.7 million jobs it lost during the last recession. Yet, the GDP growth rate is not back to its pre-crisis level. The rally in equities is not over, but we are seeing early signs that the US corporate profit margin cycle has begun to turn down. Separately, it’s almost time for the Football World Cup and I pick Argentina to win.

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"Always be a first-rate version of yourself, instead of a second-rate version of somebody else.”"

The first estimate of Q1 US GDP came in at a paltry +0.1%, a full 1% below expectations. Despite this disappointment, other data in the US have been very encouraging – consumer spending has climbed higher, core capital goods orders have improved, and the manufacturing index indicated a pickup in production. The April US Jobs report released last Friday showed the largest outperformance relative to expectations since November 2013 and an unemployment rate at 6.3%, is at its lowest level since September 2008. M&A activity is clearly accelerating and is providing equity markets a much-needed tailwind. US multinational companies have accumulated $1.95 trillion outside the US and repatriating that cash to the US incurs a tax penalty of 35%. It is therefore an incentive for companies to spend money on overseas acquisitions, even at a bid premium, and gain control of a competitor rather than take a tax hit and get nothing in return. It is May and “Sell in May” headlines are back. This May I wouldn’t despair. Keep your longs, as I see very limited downside.

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"When one door of happiness closes, another opens, but often we look so long at the closed door that we do not see the one that has been opened for us."

Of all the world’s central banks, the outlook of the US Federal Reserve is the most clear: Tapering of bond purchases will continue at the rate of USD10 billion per meeting, with rate hikes expected to start by the middle of next year. The European Central Bank’s (ECB) approach is bi-polar – acknowledging the deflation risk in the Eurozone on the one hand but lacking the urgency of implementing a policy to avert it on the other. The Bank of Japan (BOJ) is still only halfway to achieving its +2% inflation target whilst the Bank of England (BoE) is debating the timing of the first rate hike (likely later this year). The S&P 500 (SPX) and particularly Tech and Biotech stocks have suffered recently. Back in 2011, stocks sold off because there was widespread concern of the US economy tipping back into recession. There is no such fear this time. Today, US GDP is growing at +2.5%, the US Jobs picture is getting better and the unemployment rate is trending lower. Therefore, it is important to keep it all in perspective and not get overly bearish. This week, India went to the polls in what may turn out to be a historic upset for the country’s long-ruling Congress party. India’s Prime Minister Manmohan Singh and the ruling Congress party have created a bubbling pot of discontent. India needs a leader that can reform government institutions and it may get such a reformer in Mr Narendra Modi on May 16. A good showing by Indian assets will be a big boost to emerging market sentiment as a whole.

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"Nobody intends to put up a wall!"
"A wall is a hell of a lot better than a war.”"

Crimea, the Peninsula on the Black Sea, has held a pivotal place in world history for over 150 years. After a relative peace of 24 years since the end of the Cold war, Crimea is back in focus as Putin looks to annexe it to Russia. The referendum in Crimea is scheduled for this Sunday and will be closely watched. All equity markets will get impacted from an escalation of the Russia-Ukraine crisis and we saw a preview of this earlier this month when the DAX in Germany fell over -3% in one day. On March 9, 2009 the S&P 500 Index (SPX) touched the lows of 666. Five years hence, the SPX is up +177% from these 2009 levels. The SPX Bull has run a good race. The only time the Bear came close to getting the Bull by its horns was in July 2011 when the SPX fell -18% over a two months period, as Europe teetered on the brink of a sovereign debt crisis. The S&P Bull at 5 is not old yet and far from running out of breath. When one talks of the corporate balance sheets now, one refers to the “cash” on it and not the “debt/leverage” ratio. Since the beginning of 2009 only $132 billion has flowed into global equity funds, while $1.2 trillion has flowed into global bond funds. The reallocation from bonds to equities is far from over. The recent February US Jobs report indicated the US economy added 175,000 jobs. The data also indicated that the number of workers in February, who had a job but didn’t work due to bad weather, was 601,000 compared to a ten-year average of 357,000. The number of workers who had reduced hours, due to weather, was 6.9 million compared to the ten-year average of 1.5 million. This is the highest reading for any February on record. It will not go amiss to say, if not for the poor weather, the job growth would have been even stronger in the US. The equity bull therefore has more legs, as the weather effect recedes.

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"The reasonable man adapts himself to the world; the unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man."

In January, the US Manufacturing Index suffered its steepest decline in two decades, dropping to its lowest level in eight months. There is no denying that the weather had a role to play in the bad data, but it is difficult to conclude that weather alone is the sole guilty party and the February data is keenly awaited. Nevertheless, a good showing in the US Jobs report this Friday is key to keeping the equity markets supported. The equity sell-off in Emerging Markets (EM) is being exacerbated by the inability of central banks to halt the decline of their currencies, despite the bold hikes in overnight interest rates and currency interventions. I have repeatedly advised to stay away from EM equities and to stay short EM currencies vs. USD, and I continue to do so. In my last newsletter I wrote “keep calm and carry on.” I reiterate this view and assure you it has not changed to “freak out and panic now.” It is advisable to look for stocks and indices that now have good upside potential in view of the sell-off. Monetary policy in the US, Europe and Japan is still on track to encourage economic expansion and growth expectations for the Developed Markets (DM) remain sound. The European Central Bank (ECB) might be right in thinking that deflation is not a threat, but at low levels of inflation the bigger risk is one of measurement error. At normal levels of inflation, overestimation of inflation may be less of a problem. At low levels of inflation however, overestimation might mean that the zone is in deflation without anyone realizing it. Later today, the ECB could cut policy rates again and/or strengthen their “forward guidance” timeline. In any case, falling inflation has to get the ECB to act with more urgency which could weaken the Euro. A weaker Euro could add some buffer back into forward inflation expectations.

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"I know not with what weapons World War III will be fought, but WW IV will be fought with sticks & stones"

Last year saw improved economic activity and reduced monetary and fiscal risks. 2014 promises more of the same. There is no denying that the US Fed’s easy money policy has helped greatly, but there have been real improvements in the US economy too. I believe that the Fed starting to pull away (albeit cautiously) will be viewed by the market as another step towards returning to normalcy. In 2014, around 40 countries go to the polls, representing 42% of the world’s population and more than half of its GDP. The political landscape particularly in the Emerging Markets (EM) could be very different by the end of the year. Incoming Fed Chair Janet Yellen has been an ardent proponent of an easy money policy to address the cyclical shortfalls of the labour market. The Fed under her stewardship, is likely to play down the 6.5% unemployment threshold and may even go a step further and reduce it to 6% or lower in Q1 of this year. Therefore, equities will have support throughout the year. In 2013, three-fourths of the S&P500 (SPX) return came from Price-to-Earnings multiple expansion, rather than higher earnings. This year, another +29% gain on the SPX is very unlikely. The healing process in Europe is underway, and more remedial action is expected this year. The European recovery theme, which investors endorsed in 2013, will remain alive in 2014 too. Perhaps 2014 is finally the year of positive Earnings-per-Share (EPS) in Europe. Japanese equities are a buy, but be prepared for volatility in March/April, around the time of the increased consumption tax coming into effect.

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"What the New Year brings to you will depend a great deal on what you bring to the New Year"

The twinkling lights on the streets and cold morning air tell us it’s almost time for Christmas. It is time to bid a year farewell and welcome another one. As for the markets this year, the global economy has returned to trend-like growth, following a very weak start. Less fiscal tightening both in Europe and the US have played a major role in this economic recovery. This year, there was no US fiscal crisis; no hard landing in China; and the European Union managed to keep both the Euro and Eurozone intact. As a result, equities soared, gold collapsed and the bond market bull was dragged back and tethered. If the S&P ends near 1800 and the 10 year US treasury yield ends at 3%, equities will have outperformed bonds by +40% in total return terms – the highest ever. The year 2014 will be a year for cautious optimism. I am optimistic about the US but cautious about Europe. US equities continue to be a good long trade and Japanese equities are also a buy. Emerging Market (EM) equities had a great Q4 as a tactical long, however, I am wary to be long EM equities beyond January when ‘tapering’ talk will likely gain momentum. USD will strengthen more against EM currencies than the developed currencies.

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"Despite a voluminous and often fervent literature on “income distribution,” the cold fact is that most income is not distributed: It is earned."

Despite a few “tricks”- tapering, an Emerging Market sell-off, and a US government shutdown, 2013 has largely been a “treat” for risk-taking investors. Inflows into equity mutual funds/ETFs in October were the third-largest on record. On the other hand, Bond funds have posted five consecutive monthly outflows, for the first time since 2003. You will recall my year-end target on the S&P 500 (SPX) is 1744 and this was obliterated two weeks ago amid the euphoria of a deal in the US Congress to avert a US default and an end of the US government shutdown. I am not tempted to raise my year-end target as I see very little upside from here. I would recommend you lock in your profits and look for more incomeyielding strategies until the end of the year. I am however by no means bearish, and have a very constructive outlook for 2014. US inflation continues to come in on the soft side. Europe encountered its own scare of deflation with new data showing inflation well below the European Central Bank (ECB) target. The most anticipated political event of the year – the third plenum of China’s ruling Communist party is set to take place this weekend. Recall, it was at the third plenum in 1978 that Deng Xiaoping announced the opening up of the Chinese economy: The move that triggered three decades of phenomenal growth.

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"If you put the federal government in charge of the Sahara Desert, in 5 years there’d be a shortage of sand"

The September US Central Bank’s “tapering” decision took almost everyone by surprise. The S&P 500 index rallied to a new high of 1730 however, since then, with the help from the US Congress, US equities have rediscovered gravity and pulled back. It is also evident that the Fed will err on the side of caution and would like to see signs of inflation picking up before dialling down monetary policy. Over the past month, several key hazards seem to have been resolved. The US Fed has kept its monetary policy supportive, current Fed Vice-Chairman Janet Yellen is back as the favourite to replace Bernanke, elections in Germany have passed and returned a more pro-Euro mandate and a potential US/Syrian conflict seems to be heading towards a global diplomatic solution. There was a time not so long ago, when the world looked to the US for both political and economic leadership. Not anymore. The current malarkey in Washington is about nothing more than egos that must be protected and soothed. In leading to the US government shutdown, neither side budged an inch in the negotiations and both sides eventually embraced a shutdown. It may be a “zero-sum” game for the politicians, but if played for too long, it could have negative implications for the economy. European equities continue to outperform and Italy’s political situation is looking more upbeat. I still recommend being long Europe, Japan and US equities. Any dip in equities caused by the US debt-ceiling stalemate, should be seen as a buying opportunity. I do not see the S&P 500 Index going below 1600. I remain positive that at the end of the year, the S&P 500 index will hit my target of 1744.

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"Do what is right and fair. The Lord accepts that more than sacrifices"

The nervousness in the market is not about overvaluation or excess flow into equities. Valuations are not expensive and the flow is on the side of equities. The real concern is regarding the uncertainty and the magnitude of the US Central Bank’s tapering announcement (expected later this month) and what diminished Central Bank support will do to asset prices. Will it lead to another big bond sell-off, sending interest rates spiking? This has the ability to disrupt the equity market and send the S&P 500 Index (SPX) towards the 1500 level. I expect the US jobs report this Friday to beat market expectations and the Fed to embark on a moderate $20 billion of tapering. Therefore, we will see the SPX reach 1600 post the tapering announcement, and perhaps lower if the Syria conflict gets messy. In my view, a bond sell-off coupled with the SPX hitting 1500 seems extremely unlikely. The Eurozone is out of recession and data out this week indicate a return to economic growth that is broad-based and not just Germanyspecific. China has not entered a slowdown as was anticipated. The problem in Emerging Markets (EM) could get worse, but a re-run of 1997 is unlikely given changed domestic structures – no USD currency pegs, more local currency debt and high FX reserves.

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"Whenever you find yourself on the side of the majority, it is time to pause and reflect"

2013 has been a buoyant year for US equities and aside from a few sputters, the rally continues. The big question is do we see a sizzle, a snooze or even a meltdown from here on out? A sizzle -and a quick move higher- is unlikely, a snooze is more likely before we resume the upward climb to the 1744 level on the S&P 500 by year end. A big market correction or meltdown very often is a result of an unexpected event appearing on the horizon. Perhaps this risk will be limited going forward precisely because such events – a slowdown in China or tapering in the US are already known. I am still positive on US equities, however I am more comfortable shifting the allocation from overweight US equities to a more balanced US-European equities mix. Over the next two quarters, European equities offer a better return than US equities. Emerging Market (EM) equities have stopped declining as more long-term money finds its way back to these countries. Japan is a structural long trade, if you can stomach the volatility.

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"All that we are is the result of what we have thought. The mind is everything. What we think we become"

Since its peak in May, the S&P 500 has run into a number of headwinds: Doubts about Abenomics in Japan, tapering in the US, a self-inflicted credit crunch in China, capital flight in the Emerging Markets, a government overthrow in Egypt, and so on. However, we haven’t seen any panicked sell-offs. The stock market is placing each issue in context. This is a good thing. Slowly but surely, different sectors and aspects of the economy are returning to more normalized pre-Lehman levels. The US is on an upswing. As the Emerging Markets have recovered and then cratered, the US market has recovered and then recovered more. The US stock market, the US economy, and the US Dollar are all at the top, relative to their peers in Europe, Japan and the Emerging Markets. However, September 18 is still on track to be the day the US Federal Reserve makes its ‘tapering’ announcement. Should we be afraid of tapering? Of course not. European stocks have not done as well as their US counterparts this year. For H1, the US was up +12.63%, compared to flat or negative performances for the UK, Germany and France. I strongly believe that this quarter could be different. European companies are taking advantage of low borrowing costs and given the “kitchen sink” work must be over by now, it is time for earnings in Europe to start bearing the fruit of the repair work of the last few quarters. I expect European company earnings to surprise to the upside and therefore I would be overweight Europe v/s US this earnings season.

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"There is nothing noble in being superior to your fellow man; true nobility is being superior to your former self."

The two big macro themes that have concerned the markets recently haven’t changed – the Fed’s Tapering and Abenomics. US Treasuries saw a 50bps rise in yields during May yet the SPX had a positive month. The Fed Chairman Ben Bernanke must certainly be pleased so far by the market reaction to the talk of tapering. What we saw in the markets in May was “volatility” and not “weakness”. Selling in May, didn’t pay. In my May newsletter, I suggested – don’t be a grizzly bear (sell the equities and go short the market) but be a teddy bear (stay invested and buy some out-of-the-money Puts). I still have the same advice for the month of June. The deterioration in German retail sales and the rise in the number of unemployed in Germany have focused the minds that the malaise in Europe could be heading to the core and there is expectation of further European Central Bank (ECB) actions. Rising home prices, declining initial jobless claims and better job creation numbers are boosting US consumer confidence. This bodes well for the US equity markets. Despite the recent correction, the medium to long-term case of Yen weakness and Nikkei strength remains. I would advise against investing in commodities at this time, unless the macro picture for China and the global economy gets clearer. Gold bears will continue to win and so will Copper bears.

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"Art is the only way to run away without leaving home"

We saw broad-based weakness in the momentum of US economic indicators during the month of April. The housing data was the lone bright spot. The US Federal Reserve left its asset purchase and interest rate policies unchanged. Yet, officials did alter their statement to say that they are prepared to increase or reduce the pace of asset purchases as conditions warrant. This has helped the equity markets rally even as the macro data has been showing signs of weakness. The European Central Banks (ECB) signaled its intent to tackle the problem of lacklustre lending to small business. If the European Investment Bank (EIB) steps in to provide credit guarantees, securitize these loans and transform them into high quality assets that the ECB would readily accept as collateral, it could be a game changer in Europe and positive for European equities. I still prefer US and Japanese equities though and would look to buy some protection on the S&P 500. My FX views are Short EUR/USD, Short GBP/USD and Long USD/JPY.

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"Coming together is a beginning; keeping together is progress; working together is success."

With every passing day, the Eurozone resembles the legendary Potemkin village – a fake construct that hides behind its facade a potentially damaging situation. Every time there is a crisis, the Eurocrats in Brussels have a new “construct” to calm the markets, but the picture behind the scenes is getting worse. If the original Potemkin village was a small settlement, the Eurozone is a Potemkin village on a Jurassic scale. Nothing will ever change the reality in the Eurozone – the individual countries have very different underlying productivity rates, as well as social and political systems and therefore a fixed exchange rate (the Euro) cannot bind them together without straitjacketing and destroying some of them (as is becoming evident now). Amid the Eurozone gloom, hope springs eternal for the US economy. February personal spending numbers, released last Friday, suggest the US economy grew at a clip over +3.5%. No doubt the “wealth effect” of increasing house prices is fuelling this rise in personal spending of US consumers. Despite my bullish views on the US economy, I expect things to slow down in Q2 as the impact of Sequestration grows and the debt ceiling debate is back in focus. The seasonal trend of a strong Q4 and Q1 followed by a weak Q2 could materialize yet again.

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"Nothing in the world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent."

There was no “Silvio lining” in the Italian election “playbook” but it was not uneventful by any means and, if anything, the concerns have grown rather than receded.

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"The fundamental cause of trouble in the world is that the stupid are cocksure while the intelligent are full of doubt."

It’s Back to the Future for the markets. Last week, both the Dow and the S&P traded at five year highs with the Indices hitting 14,000 and 1500 respectively. Every time the US market trades at a multiyear high, fears of a pullback descend. Keep in mind however that back in 2007, the US unemployment rate was 4.7%, the 10 year US Treasury yield was 4.68%; both indicators (as we now know) of an overheated economy at the top of the economic cycle. Today, the 10y US Treasury yields 1.98% and the unemployment rate is at 7.9%, both far from a cycle top. Downside risk also remains supported in the medium term by an extraordinary mix of central bank actions and fiscal policies we have seen thus far and they are set to continue. So what could go wrong? The lifeblood of this rally can be traced back to Europe and ECB President Mario Draghi’s actions and July 2012 speech, it is therefore imperative for Europe to resolve the upcoming macros issues favorably – the Italian elections, the future of Cyprus in the Eurozone, Spain’s budget, and the negotiation of Ireland’s existing bailout package. We may have to contend with a volatile February as US budget sequestration and Italian elections loom, but the risk remains to the upside.

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"We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle."

The “fiscal cliff” deal does little to alleviate the uncertainty that remains about US fiscal policy this year and beyond; it is nonetheless positive for the US economy and the compromise made by both sides of the Congress is a significant first step. The political dogfight notwithstanding, investors should look beyond the headlines and not miss the wood for the trees. My base scenario is that there will be a long-term fiscal deal struck during the two year life of the 113th Congress that takes seat in Washington DC this month. In the US the manufacturing data is much stronger than forecast. Beyond the US, Europe is likely to stay stable not least because Germany has its elections in September this year; Italian elections in April look less of a destabilizing effect, the ECB’s OMT is in place and ready for use. Chinese growth is more robust than most expected. Despite the postponement of spending by consumers and corporate alike, it is also a fact that eventually the car breaks down and needs to be replaced, and so does the plant equipment. This is what drives the economic recovery. As the next round of jawboning in the US Congress starts and “debt ceiling” negotiations intensify, I expect the initial rally in equities to lose steam before the end of Q1 and endure a volatile Q2. My end of year target for the S&P 500 is 1554. A modest +7% upside from current levels but a +14-16% upside if you can pick the dip in Q1-Q2.

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"Was there ever a people whose leaders were as truly their enemies as this one?"

As US GDP growth inches to the +3% level, China’s official manufacturing index hits a 7-month high and a Greek exit from the Euro is off the table (for now), the outlook for equities has gotten better and is likely to keep improving. We will see more investors gradually leaving the safety of bonds and gold and moving into equities. The risk of not being in equities and missing out, is greater than holding equities and having temporary reverses. The case for US equities is still positive with a preference for cyclical sectors, however I am more positive on Emerging Market (EM) and European equities due to a higher upside potential. I forecast the S&P to finish 2013 at 1554, i.e. a +10% upside from Friday’s close of 1416. Come Q1 2013, I forecast that Spain will ask for a bailout, that the ECB will activate the (Outright Monetary Transaction) OMT and will buy Spanish bonds aggressively and that Spanish 3 year bond yields will narrow from the current 3.4% to under 2%. A “risk on” accompanied with additional US monetary easing means Gold will see a slow grind up. Energy prices will continue to drop as US shale gas becomes a hot topic of discussion. Look out for overheating in the investment grade bond market by mid-year and mark your exit.

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"When plunder becomes a way of life for a group of men living together in society, they create for themselves in the course of time a legal system that authorizes it and a moral code that glorifies it."

It’s not just the US that may have a new leader, the world’s second largest economy, China, will most certainly have a new leader as the political cycle in the two economies coincides next week. While the market has been focused on Europe all of this year, what happens in the US and China post-elections, will dominate the agenda over the coming months. Policy gridlock in US and a policy vacuum in China will likely give way to new announcements and new actions in both countries. Despite the macro risks overhang this year, Equities have done well and the rally has come to be known “the most hated rally.” The reason for the rally is simple – liquidity trumps. The recent decline that we have seen in the S&P 500 came when the vast majority of economic data were all better than expected. Fiscal policy uncertainty is likely to keep things volatile but I have little doubt that the “fiscal cliff” will be averted regardless of who is in the White House come January 2013. The fears of a hard landing in China have proven unfounded, economic indicators suggest China’s economic plans are on track and the “stimulus” powder is still dry, if it needs using. Any EUR rally is likely to get capped at the 1.35 level. Gold is a long term buy; however trading 10% rallies and sell-offs could still bring returns from an asset which moves higher in spurts and could be range bound for months.

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"The budget should be balanced, the Treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt. People must again learn to work, instead of living on public assistance."

October is traditionally a scary month for equities. One-fourth of all equity crashes (including the big ones in 1929 and 1987) have happened in October. Last month, Federal Reserve bank Chairman Ben Bernanke delivered QEternity (open ended Quantitative easing of $40bn bond purchases per month) and now we are faced with a ‘fiscal cliff’. If the history of this Congress is any guidance, bickering aside, at the eleventh hour, the ‘fiscal cliff’ will be averted. US Manufacturing data released this Monday by the ISM (Institute of Supply Management) bucked the trend by rising to 51.5 from 49.6 previously. This snaps a string of three consecutive sub-50 readings. The details behind the headline were also better than expected, as new orders and employment both rose. I maintain my positive view on equities over bonds. The weakness we have seen towards the end of September will be bought back and most certainly in the rally that will ensue when Spain asks for a bailout and the OMT is activated. Recently, when President Obama was asked about his biggest mistake, he said it was ‘messaging’, not, ‘policy’. If policy prescription is right, big economic declines are followed by a big economic recovery. The recovery that followed during January 1983 – December 1985 resulted in a cumulative GDP growth of +18.95%; this time around, in the period from July 2009 – June 2012 cumulative GDP growth was a subdued +6.75%.

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"You should always be aware that your head creates your world"

Bernanke’s Jackson Hole Speech may have threaded the QE3 needle but it may be premature to conclude QE will be announced at the September FOMC meeting. In reality the Fed doesn’t have to actually do a QE to keep asset prices from falling. The fear of any Fed action will be enough to keep the bears at bay. Only a worsening US Jobs report (less than 100k print) will make QE3 a sure bet. The macro data in Europe is not improving – manufacturing is down, unemployment is up, consumer confidence is down and the economy is still contracting. The ECB’s bond buying plan is welcome but you can’t wax a car and hope it fixes the engine. Europe needs structural changes. If the Euro is not to resemble a dead autumnal leaf floating on a pond, Europe and particularly Germany will have to agree “sharing is indeed caring” when it comes to normalizing the sovereign bond yields prevalent in the market today. At Thursday’s ECB meeting – I expect 0.25% rate cut (a non-event rally), no clarification on the issue of “seniority” of bonds ECB purchases and a likely commitment to unlimited bond buying in the 2-3 year duration. The ECB will also assure the market that there is no challenge to such a policy and that this action does not contravene its mandate.

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"People often say that motivation doesn’t last. Well, neither does bathing – that’s why we recommend it daily"

Mr Draghi’s comments of ‘whatever it takes’ indicate Europe is finally ready to move beyond the preamble of solving the Eurozone crisis. This afternoon’s ECB rate meeting is eagerly awaited. My gut feeling is the deposit rate could be lowered to negative territory and the sovereign bond purchases restarted alongside more verbal assurances of strong action. Spain is on precipice. As late as early July, the Spanish government was telling everyone, “Spain doesn’t need a sovereign bailout”. It is now almost certain they can’t do without one. Spanish debt cost is spiraling at the short end too. With the country’s ratings under review, a downgrade now could cut Spain’s access to the bond market altogether. For me, this is the inflexion point in the Euro crisis and could be the reason for the recent bold comments from the ECB. The US Fed’s QE3 is likely to come at its September meeting. US Q2 earnings have not been bad but revenue expectations have lagged. However, the fall in consumption and income have bottomed and real spending is turning into a shallow uptrend. US Q2 GDP growth of 1.5% though small, keeps recession at bay. Slow growth with incredibly loose monetary policy bodes well for Equities. Large-cap US stocks are still the place to be, in the Industrial and Energy sectors in particular. Euro weakness will stay and GBP’s rehabilitation continues, at least until the UK gets downgraded..

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"What we think, or what we know, or what we believe is, in the end, of little consequence. The only consequence is what we do"

The last EU summit was a change from the cul-de-sac policy responses we have had so far. Hopes of an exit to a US TARP-like solution to the European banking crisis were raised but details remain sketchy. The concessions that Ms. Merkel has made are unlikely to be a perpetual shakedown for Germany’s cash at every forthcoming summit meeting. Eventually she is likely to pull a Miss Havisham on peripheral Europe’s Great Expectations. There have been reports that Ms. Merkel does not expect the concept of Eurobonds to see the light of day during her lifetime. Perhaps then, the Euro is dead, but for the burying. One reason the crisis is dragging on is that there is no incentive (or penalty for that matter) for Germany to resolve the debt crisis quickly. The Euro helps Germany, so it will keep it as long as possible. The sub 50 reading of June US ISM manufacturing number is the clearest sign yet that the slowdown from weak economic activity in Europe is now hitting the US too. The Q2 earnings season is expected to be a weak one. I have a feeling it could be a tough July, like the one we had last summer. It is likely the US FOMC meeting on August 1 could be the point Equities find favor again. If I were on holiday now, I would not hurry back..

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"How do you tell a Communist? Well, I predict future happiness for Americans if they can prevent the government from wasting the labors of the people under the pretence of taking care of them."

The Facebook IPO has come and gone and it has made Mark Zuckerberg a billionaire – many times over – and a Sucker-berg out of all retail investors who rushed in. Hype is not value. My fair value for a Facebook share is $20; however, I would wait to hear more about the company’s revenue growth plan before buying the stock even if it gets to this level. Greece has proven the point made by Margaret Thatcher about Socialism: eventually you run out of other people’s money. Germany is faced with two impossible outcomes – they take losses on the debt extended so far and suffer from, a rising Deutsche Mark (if the Euro then breaks up), or they tolerate high inflation and bear yet more fiscal transfer, if the Euro carries on as it is. Since it is difficult to work out the cost and benefit of each option just yet; the evidence so far suggests that Germany may be willing to give political integration in Europe a shot. The recent pullback in equity markets globally was primarily driven by the May 6 Greek elections, and fear of a Greece exit (or Grexit). I do not believe either a Greek exit or a Spanish bankruptcy is on the horizon. I am more inclined to believe that further ECB easing and European bank recapitalisation on the scale of the US (think TARP 2008), are the next actions in Europe

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"How do you tell a Communist? Well, it’s someone who reads Marx and Lenin. And how do you tell an anti-Communist? It’s someone who understands Marx and Lenin."

An amiable apparatchik by the name of François Hollande has one foot in the door of the Elysée Palace and European policymakers, having flirted with austerity and gotten GDP growth numbers with a negative sign in front, now seem to have rediscovered a liking for growth. In the US, the economic data so far is still pointing to more upside in US equities and the strong manufacturing data out this week reiterated the growing strength of the US economy. Therefore I wouldn’t follow the adage of ‘sell in May and go away’. In fact, this year, I would definitely stick around. I believe that the ECB will play a larger role sooner than later and therefore I am turning more positive on European stocks. The ECB is the only reliable fire brigade Europe has and not using it to fight the fire of the sovereign debt crisis is madness. I maintain my bullish view on Gold. Gold is not just a weak US dollar play, but a play against paper currencies of any color.

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"Central bankers always try to avoid their last big mistake. So every time there’s the threat of a contraction in the economy, they’ll over stimulate the economy, by printing too much money. The result will be a rising roller coaster of inflation, with each high and low being higher than the preceding one."

The two doses of LTRO that Europe got were just the vitamin and not meant to be penicillin. The growth prospect in Southern Europe looks dire and austerity targets ambitious. The first quarter rally in the S&P 500 has been the best in over a decade but will the market continue to bloom this spring? The US Jobs report out on Good Friday and the Q2 earnings season starting 10th April will provide us with the answer. I am cautiously optimistic for Q2 earnings and therefore think the market could rally all of April. Two factors have been key influences – good macro data from the US and a reward (albeit delayed) for last year’s US corporate earnings. It is attractive to be a contrarian but one can only be a contrarian at the ends; in the middle, one is a trend follower. We still seem to be in a good data trend from one economy that still matters more than others – the US.

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"I never hesitate to tell a man that I am bullish or bearish. But I do not tell people to buy or sell any particular stock. In a bear market all stocks go down and in a bull market they go up."

The second Greek bailout is not a gift. It is a one-pronged austerity drive with no provision for growth. If the Eurozone is to be kept intact, Peripheral Europe will need a plan on the lines of the “Marshall plan,” which engendered the highest rate of economic growth in European history, to carry out reform. The ECB’s two rounds of cheap funding, LTRO, have not eliminated the risk of systemic failure, they have merely taken it off the table. Let’s keep in mind that a trillion Euros of additional bank debt will make any systemic failure in the future even greater than the one we are faced with today. Whether the LTRO liquidity is used by banks to pocket the spread on the carry trade, or lend more to the real economy, will shape what direction the crisis takes next. While I feel encouraged by the improving macro conditions, particularly in the US, and the risk to the market remains more to the upside than the downside, elections in April and May in Europe could cause volatility. The historical strength of the Japanese Yen has hurt the Japanese Equities market in the past, but recent JPY weakness could be here to stay, with the Nikkei being the prime beneficiary.

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"Even if you’re on the right track, you’ll get run over if you just sit there."

The Q4 US GDP growth brought us not three cheers but two. The ECB’s 3-year financing facility has given risk assets wings and we have seen a spectacular rally over the last two months. The trend is your friend…until it bends. The test for this rally will be the end of the second ECB financing facility on February 29, with no provision for a third allocation penciled in. The Greek PSI (public sector involvement) deal has so far proven to be more elusive than the artist Banksy. For me, a political discord in Europe is the single biggest risk this year. I am cautious in the short-term and constructive in the medium term. If the new macro data fail to confirm the good numbers we have recently had (especially in the US), a pull back is possible. However with the Fed hinting of QE (Quantitative Easing) and the ECB more supportive in Europe; equity markets will continue to find a safety net for a rally to restart should there be a pullback.

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"Successful investing is anticipating the anticipations of others."

Interest rates are not expected to rise until 2014 and Europe’s problems are not going to be solved quickly, therefore income generation is still the investment theme for the year. As recession takes hold in Europe, I expect Q1 to be challenging with pressure on the ECB and European authorities to act strongly. Recent Italian debt auctions may have completed successfully but a 7% yield remains a prohibitive cost. Ultimately, this will spark the urgency to implement the fiscal measures proposed at the last European summit. For 2012, I forecast a sovereign default within the Eurozone and a ratings downgrade for France but a narrow election victory for Sarkozy. The EURUSD will trade near 1.20, and Gold’s recent correction will prove overdone. Emerging Markets will recover in the second half of the year, US GDP growth will hit 3%, and Obama will get re-elected (much to my disappointment).

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"It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. "

When economies fall apart, it isn’t just the guilty that get punished. Exports make up forty percent of Germany’s GDP, so they can ill-afford to go back to a strong deutsche mark. The talk of a Eurozone break up is overdone as the ECB will step in as lender of last resort and buy European debt. In keeping with ‘never let a good crisis go to waste’, Mrs. Merkel’s intransigent stance is to extract the best deal for Germany in a dangerous game of who blinks first. The bottom is not going to fall off the markets in 2012 and US equities are preferred over European equities. Swap lines from central banks will keep the credit crisis in check but high sovereign indebtedness means books have to be balanced; a recession in Europe will follow and our best hope is for it to be a shallow one. As more money is printed, Gold still looks good. China’s desire to shift to domestic demand-led growth will be a key decision impacting global markets. It will cut rates and it will cut reserve ratios too and this should engineer a soft landing in China.

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"The most important rule of investing is to play great defense, not great offense. Every day I assume every position I have is wrong. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead. Always maintain your sense of confidence, but keep it in check "

Recessionary fears in Europe exist but the US and the Emerging Markets (EM) look much better placed as economic data over the last few weeks have surprised to the upside. Central Banks continue to be in a monetary easing mode with the rate cycle in EM turning, inflationary fears receding and rate cuts to support growth looking more likely. The EM bullish case remains strong as do the cases for high yield credit (to take advantage of the recent sell of), Russian Equities (for valuation reasons) and large cap European and US equities that have lagged the benchmark. We recommend no credit or equity exposure to European peripheral economies. The message is some dislocations take a long time before the final solution is reached, and as an investor, it pays to be nimble and tactical with a shortened horizon. Overall, the risk is more to the upside than to the downside.

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"It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong."
"October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February. "

The Bond market is still pricing in a recession ahead and when bonds and equities disagree, the bond market usually wins. The Fed dissenters and the Republican Congressmen kept the Bernanke Fed from expanding its balance sheet. ‘Operation twist’ may not be too much of a help. If conditions worsen; expect the Fed to carry out another round of QE. In the near term, Europe leveraging up the EFSF and a good start to Q3 earnings season has the potential to deliver a short term rally in equities, but it’s not one to participate in without insurance. Dollar strength has wiped some glitter from Gold, but the case for Gold remains solid.

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"In stocks you’ve got the company’s growth on your side. You’re a partner in a prosperous and expanding business. In bonds, you’re nothing more than the nearest source of spare change. When you lend money to somebody, the best you can hope for is to get it back, plus interest."

In Ben we trust; further QE will likely push double dip fears into next year. Gold should continue to benefit from fears of sovereign debt defaults and currency degradation. The Euro will survive but expect the strong members to exit and to see its recent strength wane. In the current environment, income not capital growth should guide us. Buy stocks for income and pick high quality stocks over high yielding bonds.

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